Purchasing an investment property can be an expensive proposition
Costs to consider when investing in residential real estate
- You need a 20 percent down payment on investment properties.
- Mortgage interest rates are higher in investment properties.
- Plan to renovate before you rent or flip the house, and expect cost overruns during construction.
- Include hazard insurance, property taxes, association fees and maintenance costs in your monthly budget.
- Have enough cash reserves in the bank to cover costs for six to 12 months.
If you're thinking about purchasing a home as an investment — either to flip it for a quick payoff or to rent it out for a steady income stream — you will need a lot of money in the bank before you even begin.
Down payment and closing costs
First of all, you will need a 20 percent downpayment for an investment home. Mortgage insurance — which is required any time you have less than 20 percent equity in a home — is not available on a property you don't plan to use as your primary residence.
So, to purchase that $150,000 investment property, you will need to put $30,000 down, and none of that can come from gifts. There are other options for raising this money, but all of them are expensive and risky. You can use credit cards, home equity lines of credit on your existing home, or go to a hard money lender for a short-term loan. This last option is best used if you plan to flip the property because you can then pay off the loan with proceeds from the sale.
On top of the downpayment, you will have to pay closing costs (unless you can convince the seller to pay them), and your interest rate on an investment property will be at least three-quarters of a point higher than the interest rate you could get on a home you plan to occupy.
Renovation and repair
After closing, you will face new expenses. First, you will most likely need to renovate the home before you can rent it. Expect to spend several thousand dollars on renovations before you see a dime of rent on even the best rental property you can afford.
Obviously, for a fix-and-flip, your renovation costs will be much higher, and you will need a contractor to help you determine the extent of renovations needed. Even then, expect to find additional issues that need fixing and a budget for overruns. Then, you will have ongoing costs that need to be paid for, including:
- Home-owner insurance
- Property taxes
- Homeowner association fees (possibly)
- Utilities, given water, sewage and trash may not be covered by renters, while gas and electric will be your responsibility in between renters;
- Tenant-search fees, including advertising costs, and background and credit-check fees; and
- Maintenance fees, including repairs, which are the obvious piece of this, but don't forget about pest control, landscaping and general maintenance — such as weekly lawn care, snow removal, light-bulb replacements, etc.
If you are renting the property, the rent will need to cover these costs before you see any profits. Plus, these ongoing expenses will eat into your reserves during the months that the house sits vacant. If you plan to flip the house, you will need to cover these costs until you sell the property. Plus, you will have additional costs, such as permit fees to add to your budget.
When you go to purchase your investment property, the bank may require you to have sufficient reserves to pay for all of these expenses — plus your own personal expenses — for a period of six months before they will give you the loan. Many experts say you will want to have 10 to 12 months of what you plan to charge for rent in reserve to cover maintenance costs and vacancy periods. You should allow for two months of vacancy per year when determining your budget and deciding how much rent to charge.
All of these costs can add up quickly, so don't just jump into the investment market because you found the perfect home in a great neighborhood. Make a plan, create a budget, double that budget to account for cost overruns and emergencies, and check market rental rates in the area to make sure you can cover all of your costs and still make a profit. Doing due diligence upfront can save you huge losses down the road.