What to expect if you’re thinking about buying an investment property

Many people dream of owning real estate that nets them a rent check each month, but knowing what you might actually make and how to get started as a real estate investor aren’t always that easy to understand. So we asked pros for their advice. (See the lowest mortgage rates you might qualify for here.)

The first thing to know is that expected returns for first-time investors are pretty low, at least at first. “As you gain experience, your returns should improve as well as your knowledge of tax implications, which are generally very favorable for real estate investors,” says Edward Mermelstein, an attorney and private equity and luxury real estate consultant. 

He says primary markets such as New York, Los Angeles, Chicago, San Francisco and Boston will generally yield a 4 to 5 cap rate, while in secondary markets, or cities with populations between 1 and 5 million people, that cap rate is 6 to 10. A capitalization rate is the net income a property is expected to generate, and is determined by dividing the net opening income (all revenue from a property minus necessary operating expenses) by the current fair market value. “The range of investment needed will depend on the market, so you can expect $500,000 to $1 million that will need to be deployed to earn $50,000 per year,” says Mermelstein.

This may make it sound like you need to be super wealthy to buy an investment property but not all people who own investment real estate properties are bigwig investors. Data from the Internal Revenue Service reveals that approximately 10.6 million American tax filers declared rental income in 2019, and the US Census reports that landlords have an average income of $97,000 annually. According to Rent.com, landlords earn 44.8% more annually than the median household income in the United States. 

Understand the ways you can make money

Larry Pershing, certified financial planner and founder and CEO of Optimum Retirement Planning, is also the owner of a 3-unit apartment building. He points out that there are four big ways to profit from investment properties: 1) Cash flow, where you receive more rent than the expenses of the property; 2) appreciation, when the home value increases; 3) debt pay down, when your tenants pay down your mortgage, which increases your equity; and 4) tax benefits, which let you take a phantom expense called depreciation to account for the fact that your building gets older and loses value each year. 

“Owning investment properties can [sometimes] produce higher returns than more passive forms of investing such as investing in the stock market.  However, it’s also more effort and higher risk,” says Pershing. Indeed, depending on one’s investment style and the type of returns one islooking for, real estate isn’t always a better option than investing in stocks. Typically, however, real estate hedges inflation and there’s also a low correlation among other asset classes. So if stocks are down, real estate values are often up. Plus, with the added benefit of tax advantages, rental income, and the ability to leverage a real estate investment, investing in real estate often outperforms investing in the stock market. (See the lowest mortgage rates you might qualify for here.)

Get versed in the costs

For investors looking for cash flow rental properties, Ignacio Villanueva, director of sales at Compass in Miami, says, “Be sure to have a detailed list of fixed carrying costs like taxes, HOA fees, and insurance, in addition to budgeting for unforeseen costs and repairs. When running numbers, buffer in and assume a vacancy one months every year to prepare for a potential gap between tenants.” Mynd Property Management offers some insight into average and hidden maintenance costs for rental properties, and Zillow has a rental property expense estimation tool where costs like maintenance, insurance, property taxes, HOA fees and more are detailed.

According to 2018 data from the National Association of Realtors, the average annual operating and capital expenses per rental unit was projected to be $830 in 2020 which includes costs like real estate tax, maintenance, payroll for employees, property insurance, water and sewer costs, electric and gas, grounds and landscaping, security and more. 

Know your real goal

Think about your objective as it will inform what kind of property you’ll buy. “Do you want to buy a place, renovate and sell it quickly? Do you want to become a landlord?” says Holden Lewis, home and mortgage expert at NerdWallet.

Consult the right pros

“The most important thing to consider is your team,” says Mermelstein. That means picking a broker who has sold and dealt with investment properties and can share those insights; hiring an accountant and financial adviser to discuss costs and taxes related to investment properties; and retaining a lawyer for landlord/tenant issues. “Your team will guide you on location, numbers, and potential pitfalls,” says Mermelstein. 

Nail the location, on multiple levels

Mermelstein says that location is one of the first things to consider when thinking about buying an investment property. And you should weigh location using a variety of factors.

The first factor to think about is if you plan to manage this property yourself — or have someone do it for you. “The best locations tend to be either near where you live or near strong property management teams,” says Mermelstein. Look into what property management will cost you and what it includes (and doesn’t include) if you’re considering going that route. On the flip side, consider the time and effort it may take you to manage the property on your own 

The second thing to consider is that you will likely need a pool of quality renters. “If employers are hiring and incomes are rising, there will [likely] be rising demand for housing and a wide variety of commercial real estate,” says Jilliene Helman, CEO of RealtyMogul, one of the top real estate crowdfunding platforms. That said, she cautions: “Even if an area has population, jobs and income growth, if it’s already highly developed, those factors have likely already been factored into asset prices.”

Plenty of other factors matter, too: Helman recommends looking for places with low housing supply and high demand, choosing areas within proximity to transportation arteries where commuting is easier,  and paying attention to how close the property is to amenities such as grocery stores and other shopping. In addition, says Helman, “ We always pay attention to how safe a community is and how much or how little crime occurs.”

Considering location and the price-to-rent ratio can also benefit real estate investors. Typically, a lower price-to-rent ratio means conditions are more favorable for buying a home, while a higher ratio makes way for a more favorable renting dynamic.

Know the downsides

Though the endgame of owning an investment property may sound appealing, it is still subject to certain downsides. “Real estate is not as liquid as stocks or other investments where you can buy, sell or pull out your money anytime you want. Real estate is generally a longer-term investment,” says Helman. 

Problematic tenants are another potential drawback. “This is why it’s very important to have a good property management company that carefully vets and performs background checks on prospective tenants,” says Helman. And as with all real estate, maintenance issues and unforeseen repairs caused by weather, tenants, general wear and tear, or structural issues that weren’t caught by inspectors can also wreak havoc on an investor’s payday.