Real estate can be a great investment, but it's important to consider these tips and potential risks. Here's what to know before buying investment property.
For many investors, investment properties can be a solid addition to your portfolio. Real estate investments are an alternative asset to the more standard stock and bond investments in most portfolios.
In many cases, an investment property can provide an income stream, a hedge against inflation and overall portfolio diversification. Investing in property is different from other types of investments in that it is relatively illiquid, and you may have to obtain financing to make the investment.
If you're in the market to purchase an investment property, there are a few considerations you should keep in mind.
When purchasing real estate, it's often said that location is the main consideration—this is true with an investment property as well.
If you're looking into various types of rental units (an apartment building, a house, a condo unit(s) or others), make sure to look at the property’s location. How is the demand for housing in the area—is it an area where people want to live? There are many factors that can attract different types of people to the area; good schools can attract families, being close to a main business district in the city can be attractive for urban areas or it could be close in proximity to entertainment, shopping, dining, etc., which is desirable for another subset of people.
You'll want to fully understand the pros and cons of a property’s location prior to investing as this can have a big impact, not only on your ability to find tenants but also on the future value of the property if and when you'd like to sell.
Management and Ownership Issues
Before buying an investment property, make sure you're on top of the various issues connected with managing and owning the property.
Especially in the case of a property that will be rented to tenants, the property has to be managed. It will need to be maintained and new tenants will need to be found if a tenant decides to move out after the end of their lease. As a landlord, you need to ask yourself if you are willing and able to fix broken toilets, mow the lawn and do other maintenance on the property. How about collecting rent and finding new tenants? If these aren't tasks you're particularly up for handling yourself, it may make sense to hire an outside property management firm.
If you're interested in going the property management route, the ongoing costs of hiring the firm, plus the ongoing costs of maintaining the property should be factored into your purchasing decision and how much you're willing to pay as an investor.
The costs of maintaining and managing the property should be a key part of the cash flow analysis you do as a part of making the decision as to whether or not to invest in the property. Other components of the cash flow analysis can include:
- What will the costs be, if any, to get the property ready to be able to rent? This can vary widely from property to property but can be a sizable outlay that will need to be made prior to earning any rental income.
- Will you be able to charge enough in rent to cover the costs of ownership such as taxes, mortgage payment, property management and others and still make an acceptable profit on the investment?
- An important part of this analysis is to ensure that you factor in all costs of purchasing and owning the property upfront to mitigate the impact of any potential negative financial surprises down the road.
When deciding whether to purchase an investment property, there are a number of investment-related issues to consider.
A key consideration is how the purchase of this investment property, and investment properties in general, fits with your overall investment strategy. If you're considering the purchase of your first investment property, your goal might be to diversify away from more traditional holdings like stocks, bonds, mutual and ETFs.
If you already invest in real estate, you'll want to consider how this property might fit with their existing investment real estate holdings.
You should also be prepared with how you'll be purchasing the property. If you'll be financing the purchase, you'll need to look at your credit score and the impact that may have on your ability to obtain financing at a favorable interest rate, or at all. You should also determine how much cash you're able to come up with for a down payment on the loan. The level of the monthly mortgage payment can have a major impact on determining whether this investment is financially viable for you.
Real estate is a relatively illiquid investment. Unlike mutual funds, stocks or ETFs, there is not an organized secondary market for real estate where you'll be able to readily ascertain a price for the property and sell at any point that you might need to. You should determine how this aspect could impact your financial situation and if you're able to tie up cash in this investment for a period that might entail a number of years.
Potential Risk Factors
Like any other investment, you need to weigh the risks of owning an investment property and assess whether or not you can absorb these risks. Some of these include:
- The potential for future increases in property taxes. Municipalities will reassess property values on a regular basis and taxes can go up for any number of reasons.
- Vacancies that occur over time as tenants move on. Any time the property is vacant represents a loss of cash flow that might be needed to pay the mortgage and other expenses of owning the property. You'll need to be able to sustain this hit to your cash flow from the investment.
- The impact of a downturn in the economy. This could impact investment properties in a variety of ways. This might cause the number of vacancies in the area to skyrocket, potentially forcing you to drastically lower the rent in order to attract and retain tenants. Or worse, this might result in prolonged vacancies for the property.
Investment properties can represent a solid investment for many people. Like any investment you may be considering it's important that you do a thorough analysis prior to making the investment to help ensure that it is a successful one for you.