Don’t forget about vacancies and maintenance
It’s not enough to simply subtract your operating expenses from your income. That’s a common mistake and you’d essentially be planning for an ideal scenario forever.
At some point, your property will be vacant -- maybe it just needs a couple weeks’ worth of repair work between tenants, or maybe your real estate market will slow down and the property will sit vacant for a few months at some point. Similarly, at some point, you’ll need to spend some money on maintenance.
There’s no way to predict these situations with 100% accuracy or to know when they will occur, so it’s important to set aside a portion of the rent you collect to cover them when they happen. My personal rule is to set aside about 15% of the rent I collect for vacancies and maintenance -- but I’ll adjust this a bit higher if the property is older and slightly lower if the property is brand new.
Cash flow example
Here’s a real-world example of the cash flow from a property I bought last year. The property is a triplex (three units), and rents for a total of $2,500 per month.
As far as operating expenses go, here’s what I pay:
- $1,600 (approximately) for my mortgage payment, including taxes and insurance
- $250 (10% of the rent) for property management
- $100 for lawn maintenance and pest control
This brings my total operating expenses to $1,950. Setting aside 15% of the rent for vacancies and maintenance takes up another $375 per month, which makes my total estimated ownership expense $2,325 per month.
So, my cash flow from the property is estimated to be $2,500 in rent minus $2,325 in expenses, or $175 per month. Of course, if the property doesn’t end up needing any maintenance and remains occupied 12 months every year, my actual cash flow will be significantly higher. However, it’s far better to prepare for a realistic scenario and be pleasantly surprised if things go well.
Many investors have specific cash flow requirements. Maybe they need a certain minimum amount of cash flow each month, or they want a specific percentage yield on their invested capital. Personally, I simply require that my investment properties produce positive cash flow after assuming a reasonable amount for vacancies and maintenance, but it’s important to tailor any rules of thumb to your own investment goals and income requirements.
Can you qualify for a rental property mortgage?
If you’re planning on paying cash for your rental property, you can skip this section. If not, you’ll need to qualify for an investment property mortgage, which can be just as important to your affordability question as the other items on the list. After all, if you have enough money for a down payment and have identified a rental property that produces great cash flow, it doesn’t really matter unless you can obtain financing to buy it.
With that in mind, there are two main types of mortgages you can get to buy a rental property. I’ve used both, so here’s what you need to know about getting approved for each type.
The term conventional mortgage is a broad one that generally refers to a loan that comes from a bank and isn’t explicitly guaranteed by a government agency. Generally, this means that the loan meets the lending standards of Fannie Mae or Freddie Mac, but it doesn’t have to. For example, a jumbo loan refers to a bank-originated mortgage that exceeds certain lending limits set by Fannie or Freddie and is very common in the investment property world.
For the purposes of this discussion, what you need to know about a conventional investment property mortgage is that you’ll need to personally qualify for the loan. These generally cannot be made to any other type of entity, such as an LLC.
This means that your personal credit, income, employment history, and assets will need to be sufficient to justify the loan. You can consider some of the property’s expected rental income for qualification purposes, but for the most part, your personal qualifications are what the lender will be looking at. Where investors often run into trouble is if the investment property’s mortgage payment would make your debt-to-income (DTI) ratio too high for the lender’s standards.
As the name implies, an asset-based loan is mainly dependent on the underlying asset -- in this case, the rental property you’re attempting to buy.
To be clear, you’ll still typically need to meet the lender’s credit standards. However, the loan approval isn’t dependent on your personal income or employment qualifications. The last time I obtained an asset-based investment property loan, my lender didn’t even ask to see my tax returns or any other income documentation.
On the contrary, the main qualification is whether the rental property you want to buy will deliver enough cash flow to justify the mortgage. Asset-based lenders use a metric known as the debt service coverage ratio, or DSCR, when evaluating loan applications. This is the estimated rental income expressed as a multiple of the monthly mortgage payment including taxes and insurance. For example, if an asset-based lender requires a DSCR of 1.3, this means that if your mortgage payment will be $1,000, the property needs to bring in a rental income of $1,300.
In addition to ignoring your personal DTI ratio, another big advantage of asset-based investment property loans is that they don’t need to be made to you as an individual. In fact, many asset-based lenders prefer to loan to an LLC.
To be clear, asset-based loans tend to be more costly than conventional loans. In my experience, conventional investment property loans tend to have interest rates of 0.50%-0.75% higher than the average primary residence rate, but the premium is typically 2% or more on an asset-based loan. Still, these can be great ways to finance investment properties in many cases as long as the property still generates positive cash flow despite the higher cost of the loan.
House hacking can be an alternative if you can't afford a rental property
If you can’t qualify for an investment property mortgage, or don’t have an adequate down payment, you might want to consider a house hacking investment. This can be a great way for first-timers with flexible living situations to dip their toes into the rental property investing world.
Here’s the basic idea: A house hack involves buying a two- to four-unit residential property, living in one of the units, and renting out the others.
There are some big advantages to this investment strategy, mainly involving the fact that the property can be classified as your primary residence. You can obtain a mortgage with a lower down payment and favorable interest rate, for example. FHA mortgages on primary residences (even with multiple living units) can be obtained with just 3.5% down. You can also get the lower owner-occupied property tax rates that exist in many areas. And when you eventually sell the property, you may be able to exclude any capital gains from income tax.
In fact, my first real estate investment was a house hack. Shortly after we got married, my wife and I bought a duplex and lived in one side while renting out the other. The rental income covered most of the mortgage payment, so we were able to live extremely cheaply while building equity in a more valuable property than we would have purchased on our own.
To be clear, there are pros and cons to house hacking, so be sure to read our guide to house hacking to determine if it might be a good way for you to start your rental property investing journey.
Did you answer yes to all four questions?
To sum it up, there are several factors that determine rental property affordability. It isn’t enough to just have enough money in the bank now. You need to be sure that your financial health is strong enough to invest, that you can cover all of the costs of buying a property with some cushion in case things go wrong, that the rental property won’t deplete your savings after you buy it, and that you’re able to obtain financing.
If you answered yes to all of the questions discussed here, you could indeed be ready to take the plunge into investment property ownership.