With mortgage rates lower than ever, more Americans are scooping up rental properties to generate cash. Before becoming a landlord get comfortable with the financial risks.
The COVID-19 pandemic has produced a lot of surprises. One is the strong housing market, due in large part to rock bottom interest rates and demand for more space. Moreover, demand for second homes, both rental properties and vacation homes with rental potential, is the hottest anyone has seen in years.
“There's just been extraordinary demand for rental homes in a lot of these secondary cities, tertiary cities, suburban markets, where a lot of the single-family rental properties are located,” said Gary Beasley, CEO of Roofstock, a marketplace for buying and selling single-family rental properties.
After a lull in the early days of the pandemic, traffic as well as transactions on Roofstock have now exceeded the levels recorded last year, Beasley said. Traffic in October was up 45% year-over-year, while transactions reached the highest level the platform has registered in a single month. About 75% of the buyers who utilize the platform are first-time investors, many of whom are making the leap from renters to landlords.
“They're renting in more expensive cities and investing in properties in less expensive cities,” Beasley said. “They're becoming homeowners. It's just they're owning homes that they're not living in. They're getting a chance to build equity in a property where someone else is paying the mortgage, essentially, by renting it.”
Data from real estate brokerage Redfin further supports this assertion. Demand for second homes doubled in October compared to a year earlier, with buyers seeking properties in resort towns that they can rent out through platforms such as Airbnb.
“That's going to be a big market in 2021: the short-term rental market,” said Redfin chief economist Daryl Fairweather.
Investment properties offer cash flow from rental income and long-term asset appreciation that pays off at resale. But they are not easy to acquire. Buying a rental property can be a daunting process that requires knowledge of the neighborhood, scrutiny of the building’s physical state and savviness in securing a mortgage.
Location, location, location
A rental property in an area with good schools and easy access to jobs can be a lucrative investment. Holly Williams, a long-time real estate investor and author, recently purchased a 200-unit complex in Cary, North Carolina, down the street from the offices of software company SAS. The apartments need updating, but Williams is banking on the desirability of the location.
“I want a market where people are coming to,” she said. “I want to buy in markets where companies are moving to.”
Although the scale of Williams’ purchase is likely beyond the means of many new real estate investors, her approach to scrutinizing a deal can work for any rental property in any city.
Aside from tracking who is moving in and out of a neighborhood, Williams said she would check available apartments to compare rates and gauge what kind of rent she can charge. While platforms such as Roofstock allow first-time investors to buy rentals across the country, starting with a property close to home can be smart, because the buyers already know the market.
“Choose a familiar area,” agreed real estate broker and author Beatrice de Jong. “This is also handy so you can keep an eye on contractors while they’re renovating to make sure work is done according to your timeline.”
The physical state of the property
As is the case with most homes, a lot of rental properties will need repairs or upgrades. Eager first-time investors, however, often overlook the physical condition of the building, said Gurdeep Rihal with Century21 HomeStar in Solon, Ohio.
“As a first-time investor, you're really, really excited to jump in and get your hands dirty,” he said. “But you got to look at what type of a property you're buying and if it's really worth it or not.”
Rihal recently helped a first-time investor friend offload a rental after a gut renovation untangled a series of setbacks, including a vacate order due to hazardous lead paint, that sapped so much money he could no longer afford to carry the property.
The costs of upgrades and depreciation are usually tax deductible, however budgeting for substantial repairs and regular maintenance can be tricky. Depending on the state and size of the home or building, owners may need thousands of dollars in savings every year. Before closing, make sure to ask the seller for a breakdown of recurring monthly costs and of the major updates they have (or have not) made.
“Monthly maintenance and repairs add up quickly and can eat into your profits,” said de Jong. “Expenses cannot be more than income or it won’t make sense to buy. If you’re buying a property that hasn’t been recently renovated, you may be looking at some very expensive repairs in the near future. These may include a new roof, replacing the electrical, or new kitchen appliances.”
Any vacancies can also slim down earnings, especially for single-family homes or buildings with only a handful of units. Buyers should plan for three to six months’ worth of cash reserves to at least cover the utilities and mortgage payments on the property if it sits empty for awhile.
The pandemic-induced eviction moratoriums are adding another financial wrinkle for mom-and-pop landlords, which may give some first-time rental buyers pause. Unable to evict tenants who are not paying rent due to COVID, property owners have had to dig deeper into their stashes of cash. Since the passage of the CARES Act, however, some jurisdictions including California and New Jersey have initiated relief programs for small landlords. Still, in addition to vetting renters, first-time investors should check the local eviction rules and current government support afforded to landlords before purchasing.
How to finance an investment property
Qualifying for a mortgage on an investment property is tougher than securing a loan for a primary residence. FHA loans and USDA loans cover only loans for primary residences. So borrowers looking for a rental have to meet the generally higher prerequisites of conventional mortgages, which have even tougher qualification criteria for investment properties.
The rates on investment mortgages can be up to a whole percentage point higher than for primary residences. “The interest rates are at an all-time low, but banks are being very careful right now, having an extra set of eyes to see that their investment is secure,” said Steven Goldschmidt of Warburg Realty in New York.
Borrowers usually need to put down at least 20% of the purchase price upfront, since private mortgage insurance generally won't cover an investment property. Lenders ask for credit scores in the 680-point range for conforming loans and about 720 points for jumbo loans. Conforming loans are mortgages that Freddie Mac and Fannie Mae purchase. As such, their amount is capped at about $500,000 in most of the U.S. Jumbo loans, on the other hand, exceed that figure, which means that lenders cannot sell them off to Freddie Mac or Fannie Mae.
Moreover, if a borrower already carries a primary mortgage, their income will have to be sufficient to cover the addition of a new loan, while keeping the maximum debt-to-income ratio at about 45%. At the same time, using rental income to supplement wages is not always permissible. For loans guaranteed by Fannie Mae and Freddie Mac, “if you don't have any experience as a landlord or even as a homeowner, they're going to want your personal income to be enough to qualify for the property as if you were living there,” said Lee Hamway, loan officer with FM Home Loans.
Lenders would typically relax their qualification criteria if the borrower is purchasing a two-to-four-unit property, intending to live in one of the units, while renting out the rest. Williams calls this strategy “house hacking,” as it allows the investor to obtain a lower interest rate, use the rent income to secure the loan and save on living expenses.
Going big with multifamily properties
Single-family residences are not the only target for frenzied buyers right now. Multifamily properties are also drawing interest, despite COVID-induced eviction moratoriums.
Although it is still significantly down year-over-year, multifamily investment rose by nearly 56% in the third quarter of 2020 from the preceding three months, according to brokerage CBRE. Surpassing institutional investors such pension funds and insurance companies, private buyers snatched most of those sales. This is not surprising given that individual investors own more than 70% of the nation’s small apartment buildings, according to the National Multifamily Housing Council.
“Duplexes and triplexes are by far the most popular ones with investors,” said Gurdeep Rihal with Century21 HomeStar in Solon, Ohio. “That's the bread and butter right there. A lot of investors like that because it's a safer bet.”
While rental properties can line the path to personal wealth, investors should be prepared for the financial and operational challenges that they present.
“Real estate has changed my life,” said Williams. “It’s a tremendous investment but make sure you have a plan B and enough reserves if something goes wrong.”