We created this guide to help you understand the basics of evaluating, buying, and managing properties so you can better recognize a good investment opportunity when you see one and minimize the pitfalls associated with real estate investing.
Most people's first real estate purchase is their primary residence, but finding a good home to live in is completely different than finding a good investment property.
Life happens, and even if you have no plans to own investment property, you may find yourself in the position of having to evaluate a piece of real estate in the future. For example, you may inherit property from a family member, or you may have to move for work and decide whether to sell or rent your home.
Document your goal with regards to the new real estate investment.
If your only goal is to add real estate exposure to your investment portfolio for diversification purposes, there is a much easier way to achieve this than buying a house. You can buy a real estate investment trust, otherwise known as a REIT. It does not come with the tax benefits of real property, and the risk and return characteristics are different, but it is more diversified, more liquid (easier to buy and sell), and you do not have to be a landlord. Vanguard, Schwab and Fidelity all have publicly traded REIT indexes which hold companies that own, manage, and lease real estate properties in a variety of sectors.
Have a strong financial foundation before getting started in real estate.
If you decide to buy real estate directly, we consider it a supplement, versus a core part of your portfolio. You should first have a strong financial foundation - a secure job, a cash emergency fund, and zero high-interest rate loans. You should be maximizing your savings to retirement accounts and contributing to a 529 for your children's college, if that is a goal. Confirm you also have an adequate amount of insurance coverage, such as life and disability.
Focus on buying in areas with growing demand and amenities that strengthen the community.
Find desirable areas with low crime rates, good public schools, growing job markets, and public parks. This will help you attract and keep tenants and it will help with your home’s resale value.
Plan on purchasing a property with a 20% down payment.
Mortgage lenders typically require a 20% down payment on rental properties because the loans are considered higher risk than for a primary residence. If you are going to default on a loan, you will likely default on your investment property before you default on your home mortgage. The mortgage interest rate for an investment property is also higher for the same reason.
In evaluating potential properties, pencil out the projected pre-tax cash flow.
Pre-Tax Cash Flow = Rental Income - Rental Expenses
Rental Income - Search for rental listings online that are comparable to your potential investment properties. The results will give you an idea of what you can expect to receive in terms of monthly rental income. Helpful sites include HotPads, Zillow, Craigslist, and Realtor.com.
Rental Expenses - Determine estimates for the mortgage, property taxes, insurance, and pest control. Other expenses that may need to be included are homeowners association (HOA) fees and landscaping. A rule of thumb is to estimate that your repairs will be about 1% of the home value per year. You may also want to factor in a cushion in case the property is vacant for a month or there is a large unexpected expense. Once you have these numbers, you can calculate the cash on cash return of a property.
Cash on cash return = Annual pre-tax cash flow / Total cash invested
There are tax complexities that are outside the scope of this article, but as tax preparers, PWR will analyze both the cash flow and tax implications of a rental property for you as part of the financial planning process.
Consider using a property management company.
Property managers charge between 6 and 10% of the monthly rental income. It is possible to manage the property yourself to save money, but many people use a property manager to have a degree of separation between the tenants and avoid calls in the middle of the night with home emergencies. If you end up deciding to hire a property manager, factor that expense into your return projections.
Obtain a lease. (A property manager should do this for you if you decide to hire one.)
LegalZoom has a rental lease agreement that is customizable and easy to read. You can contact a real estate attorney if you feel more comfortable working with a professional.
Run a background and credit check on potential tenants. (A property manager should do this for you if you decide to hire one.)
Tools such as Cozy allow you to collect rent via an automated clearing house (ACH) and to run a background and credit check on potential tenants. Do not skip this step, even if you know the tenants personally. Most of the horror stories I hear from landlords are because these checks were skipped during the due diligence process.
There are unique tax benefits available to owners of real estate investment properties. Find a knowledgeable tax preparer.
Rental income is not subject to Social Security and Medicare tax in most cases. There are exceptions, such as if you are providing substantial services to your tenants for their convenience or you are a real estate professional.
A portion of your rental income can also be shielded from income tax. You are allowed to deduct items such as mortgage interest, property taxes, homeowner's association (HOA) fees, insurance and depreciation. With regards to depreciation, it is a "non-cash expense" meaning it is not something you pay for out of pocket. It lowers your tax bill by increasing rental losses, which can offset earned income by up to $25,000.
Keep records of capital improvements. If you sell the property at some point, you will need the tax basis to determine the amount of tax due. Keep receipts of all capital improvements to the property. Capital improvements increase tax basis and therefore, reduce taxable gain. Examples include replacing an entire roof, paving your driveway and installing central air conditioning.
We work with you to create a custom investment plan.
Interested in adding real estate to your investment portfolio? There are financial and tax implications that need to be considered before designing the best strategy for you. PWR can help you plan, implement, and monitor your investments to ensure they are working for you to the greatest extent possible.
Planning Within Reach, LLC (PWR) is a fee-only and fiduciary wealth management firm offering one-time comprehensive financial planning, ongoing impact-focused investment management and tax preparation services in San Diego, CA. PWR is a virtual, woman-owned firm that serves busy families and impact investors. Planning Within Reach, LLC and their advisors never receive any type of commissions for sales and do not have any insurance licenses or brokerage relationships.
Linda Rogers, CFP®, EA, MSBA is the owner and founder of Planning Within Reach, LLC (PWR). Linda is a Financial Planner and Tax Preparer located in Coronado, CA (San Diego). Linda is the Director of Investments and Compliance for PWR. Linda conducts all of the research and due diligence on PWR's Impact Focused Investment portfolios and also focuses on creating a sustainable and impact focused business plan for PWR. Linda has 13 years of experience in wealth management and works virtually with clients all over the US.