Laura answers a listener's question about the pros and cons of buying a rental property before a first home.
Laura answers a listener's question about the pros and cons of buying a rental property before a first home.
Transcript: https://money-girl.simplecast.com/episodes/should-my-first-home-be-an-investment-property/transcript
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Welcome back to Finance Friday, another special edition of Money Girl, where I answer your burning money questions! Today's topic comes from Mary, who says, “I’m 29 years old and rent in Austin, Texas, because I can’t afford to buy a home here. I have a good job where I contribute to a 401(k), I have approximately $50,000 in emergency savings, and I am happy to say that I have no debt.
What do you think about me buying a rental property in an affordable suburb and leasing it on a short or long-term basis? I appreciate any advice you have about becoming an investor before becoming a homeowner.”
I appreciate your question, Mary! I know many listeners are also struggling to become homeowners, as prices and mortgage rates have risen. It’s become trendy to be an investor before a first-time homeowner, especially in larger cities.
This post will discuss whether it is a good idea to become a landlord before becoming a homeowner. We’ll review the main pros and cons of buying an investment property before your first home.
Welcome back to episode 941 of Money Girl–I appreciate you downloading the show! I'm Laura Adams, an award-winning author, on-camera spokesperson, female money speaker, and founder of The Money Stack, a Substack newsletter.
You can learn more, ask questions, and sign up for the Money Stack at LauraDAdams.com. Also, reach out if your organization could benefit from having a remote or in-person speaker take your financial education and motivation to the next level.
Should you buy an investment property?
Depending on a property’s price, location, and amenities, there are different ways you might use it as an investment. For instance, if it’s in a location you’d like to visit regularly, it could be your vacation home part of the year, and rented out the remaining time.
You could buy a home, condo, or townhome and list it for short-term rentals on Airbnb or opt for an annual lease. If a tenant can pay all or a substantial portion of your expenses, you could break even or even turn a profit on an investment property.
However, many attached properties and homes in deed-restricted neighborhoods have rental restrictions. For example, my townhome only allows rentals that exceed three months in duration. The association aims to prevent a high number of renters from entering our community for short periods, such as a weekend or a week. Other communities may prohibit leases of less than six months or a year.
I have some friends who bought a beach condo because it allowed for short-term rentals during times of the year when they wouldn’t be there. However, within a few months, the association changed the rules and prohibited rentals shorter than six months.
Be sure to understand any rental restrictions that exist or may change in the future. Reading the past association meeting minutes is one way to determine if there has been any discussion about implementing new rules or changing existing ones. You should also ask a seller and any real estate agent representing them about current and future rental restrictions, if that’s your primary reason for buying a property.
However, before making a big decision like buying real estate, it’s crucial to assess your overall financial health and goals. Mary mentioned having $50,000 for emergencies, which is fantastic. A good rule of thumb is to keep at least three to six months’ worth of living expenses in an FDIC or NCUA-insured high-interest savings account.
Mary didn’t mention her income or expenses, but let’s say her monthly living expenses are $6,000. In that case, a good emergency savings target would range from $18,000 to $36,000. That means she’d have about $14,000 to $32,000 left to use for a property down payment, which I’ll discuss more about in a moment.
Mary mentioned participating in a workplace retirement plan and not having any debt, which is terrific! She didn’t mention how much she contributes to her retirement account, but ideally, I recommend investing 10% to 15% of her pre-tax income.
If you have a healthy cash reserve and regularly invest for retirement, you’re in a good position to buy real estate as an investor or homeowner.
READ ALSO: 6 ways to become a real estate investor
Benefits of buying an investment property
Once you’ve determined that your finances are in good shape and you want to buy real estate, consider the differences between owning a property as a landlord and a resident. Here are five main pros for buying an investment property before a first home.
1. Receiving income.
One reason to invest in real estate is to receive recurring monthly income. However, what’s more important is the net, after-tax profit you make from a property. If you can charge enough rent to cover all expenses, you’ll own an asset that someone else pays for.
Earning extra income from a rental property could be the ticket to saving more. You can use the funds for any goal you have, such as buying your own home, investing in another property, or paying down debt.
2. Getting tax benefits.
When you own an investment property, it comes with unique tax advantages that reduce your taxable gross rental income, lowering your overall tax bill.
For example, you can claim various tax deductions associated with owning and managing a rental property. They include your mortgage interest, property taxes, insurance, and operating expenses, like management fees, maintenance, repairs, utilities, legal fees, advertising costs, and any travel expenses related to managing the property.
Investment property tax issues, such as calculating annual depreciation, capital improvements, and tax-deferred 1031 exchanges, can become complicated. If you operate as a sole proprietor, partnership, or S corporation, you may be eligible for the pass-through deduction. It allows you to deduct up to 20% of qualified business income, which can include rental income.
Additionally, as a landlord, you’re a business owner and have varying legal obligations that differ from state to state. I highly recommend working with a certified tax professional or real estate attorney before purchasing rental real estate, so you fully understand your tax benefits and legal responsibilities.
RELATED: Self-employed? When and why to incorporate your small business
3. Having appreciation.
Historically, homes have appreciated an average of about 5%. According to the Shiller U.S. National Home Price Index, home values have increased by 6.8% over the past decade and 8.7% over the past five years.
However, depending on location, condition, and income potential, vacation and rental property values may have higher appreciation. But prices always vary significantly by location. So, there’s no guarantee that any property will rise in value, especially if you don’t own it over a long period of time.
4. Building equity.
As you build equity in an investment property, by paying down a mortgage or getting price appreciation, you typically have options to leverage. For instance, you may qualify for a lower interest rate and reduced monthly payments by refinancing your mortgage. Alternatively, you might consider a cash-out refinance to tap your investment property’s equity and use it to purchase another investment.
5. Being diversified.
Having a diversified portfolio is a fundamental requirement for long-term investment success. Diversification is the principle that spreading out your funds across various assets helps reduce risk by smoothing out investment returns.
For instance, if you own stocks in various sectors and industries, like technology, healthcare, utilities, and consumer goods, a downturn in one of them won’t have a catastrophic impact on your portfolio’s overall value. In addition, owning multiple asset classes, such as stocks, bonds, commodities, and real estate, is generally considered safer than owning only a single asset.
By combining assets that typically react differently to macroeconomic events, you’re more likely to experience less volatility and losses. For example, real estate has long been considered an effective hedge against inflation, offering appreciation when the cost of living and construction rise.
LISTEN ALSO: How to invest in stocks with less risk
Downsides of buying an investment property
While being a real estate investor comes with many advantages, here are five downsides of buying an investment property before a first home.
1. Paying higher upfront costs.
Lenders for non-owner-occupied, investment properties have more stringent underwriting requirements than those for owner-occupied properties. For instance, you typically must pay a higher down payment, such as a minimum of 20% to 25%, plus closing costs.
Lenders may also require a lower debt-to-income ratio and higher income for an investment loan than for a home you'd occupy. They may also require you to have a cash reserve to cover six months of loan payments in case you have variable income. Additionally, you need a cash reserve for routine repairs and ongoing maintenance that are inevitably needed for an investment property.
For example, if you want to buy a rental property for $200,000, you may need to pay 20% down ($40,000) and finance $160,000. Your closing costs could range from 3% to 6%, or $6,000 to $12,000. Additionally, you may be required to maintain a mandatory six-month payment reserve of $7,800, and an additional 1% to 3% will be needed for annual repairs, which could range from $2,000 to $6,000.
To sum up, you'd likely need to save between $55,800 and $65,800 before purchasing a $200,000 property, although it may be possible to have less. However, you may need more, especially if your lender requires a down payment that exceeds 20%.
2. Needing better credit.
Real estate investors typically require higher credit scores than regular homebuyers to qualify for a loan. For example, you may need a FICO score of at least 650 to qualify for an investment property loan.
Lenders know that tenants and rental markets can be unpredictable, which makes investment properties riskier to them. To compensate for various risks, lenders charge higher interest rates. So, loans for investment properties generally cost more and require a larger down payment.
3. Having ongoing expenses.
Whether an investment property will be profitable or not depends on the rent you can charge consistently. But an even more significant factor is your known and unknown expenses. So, carefully calculate a realistic and conservative estimate of a property’s expected income and expenses.
Real estate investors can control some expenses, but others, such as annual property taxes and insurance, can suddenly increase. If you're unsure about a property's potential costs, consult a local real estate expert specializing in rentals or an active property management company.
Some additional expenses to factor in for short- and long-term rentals include:
4. Experiencing potential losses.
The biggest drawback of buying an investment property before a first home is having losses that hurt your finances instead of helping them. For instance, you could have an extended vacancy with no rent income to offset your recurring expenses.
I can tell you from personal experience that owning a rental property isn't a guaranteed way to make money. The market or neighborhood can decline, causing you to accept lower rent income than you'd like. Your operating expenses can be higher than expected, or it can take a long time to find a qualified tenant.
Remember that during the Great Recession of 2008, housing prices dropped about 20%, which was devastating for property owners who were forced to sell homes and investment properties at a loss. I’m not saying that will happen again, but the housing market is unpredictable, and you have to be prepared for potentially lean years as well as good ones.
5. Dealing with tenants.
Before I became a landlord, I never could have anticipated the amount of work involved with managing a rental property. There are stressful situations I’ve had to navigate, such as tenants who don’t pay, get pets that aren’t allowed, or disappear at night, leaving all, and I mean all, their belongings behind.
So, I ended up hiring a terrific property manager and recommend factoring in that cost when considering a real estate investment. But even with a property manager who carefully screens potential tenants, you can end up with people who damage your property, don’t report needed repairs, or do illegal things.
A good local property manager handles day-to-day issues, such as clogged toilets, leaky faucets, noisy neighbors, rent collection, overseeing repairs, evictions, and compliance with landlord-tenant laws. They usually charge 10% to 15% of the monthly rent for a complete package of services. It’s typically well worth the cost, depending on your knowledge, skills, and ability to deal with surprises.
Should your first home be an investment property?
Whether you or Mary should buy an investment property before becoming a homeowner depends on your income, savings, expertise, and financial goals. Mary didn’t mention the price range of rentals she’s considering. But I’d guess that buying one would largely deplete her savings, leaving her financially vulnerable.
Instead of buying an investment property, I recommend that Mary continue saving for a down payment for her own home. That way, when the housing market becomes more affordable or she decides to relocate, she’ll be in an excellent position to pay as much upfront as possible, such as 20%.
Paying a higher down payment comes with several advantages. One is not having to pay private mortgage insurance (PMI), which reduces your monthly mortgage payment. Plus, lenders may offer you a lower mortgage interest rate when you pay at least 20% down, further reducing your payment. So, the more cash you can pay for a home, the less it costs you over time.
Buying and managing an investment property can undoubtedly bring severe financial challenges if you don't anticipate and plan for enough expenses.
However, when you’re financially prepared to become a real estate investor, it can bring good income, appreciation, and tax benefits that improve your cash flow and net worth over time. Done correctly, especially with the help of a real estate professional and a tax advisor, investing in real estate can be a wise way to build wealth.
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That's all for now. I'll talk to you soon. Until then, here's to living a richer life!
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