Investment Property: What It Is And Signs You’re Ready To Buy

Are you thinking about investing in real estate to rent out or use as a vacation home for travelers? If so, it can turn into a reliable source of income. But how do you know if you’re ready to become a landlord?

Before you invest in real estate, it’s crucial to understand what an investment property is, explore different types of property investments and learn how to secure financing for your investment property.

What Is An Investment Property?

An investment property is real estate purchased to generate passive income. In other words, the property can earn a return on investment through rental income, resale or both.

Investment properties are typically purchased by individual investors or groups of real estate investors. Investors can generate profits in the short term by fixing and flipping properties or renting them for a longer-term investment.

Types Of Investment Properties

Investors can buy several types of investment properties to earn passive income. Common property investment options include residential and commercial real estate and raw land.

Residential Real Estate

The most common type of investment property is residential real estate. Residential properties – single-family homes, condominiums, apartments, etc. – are intended for living.

Real estate investors tend to prefer residential real estate because once you secure a high-value property and long-term tenants live there, it can generate reliable income. However, the start-up costs are high, and you may need to wait before cash starts flowing in.

If you want to sell the property with tenants in the building, that can slow the sale while property prices rise.

Commercial Real Estate

Properties you can live in aren’t the only ones available as investment properties. People need offices to work from, hotels to stay in, retail stores to shop in and restaurants to eat at. Like a residential real estate investment, a commercial real estate investment earns income by renting out space to tenants or selling the property once its value appreciates.

As with residential properties, selling a property with tenants can slow a sale while property prices rise.

Raw Land

Raw land is an undeveloped property with nothing on it – not even buildings or crops. Savvy investors use land loans to purchase raw land to lease to farmers or keep it until a developer buys it at a profit.

Raw land is typically less expensive than developed land, making it an attractive option for many investors. However, it’s also a riskier investment because you must wait for the land to appreciate in value or find a buyer to lease it for agriculture.

3 Signs You’re Ready To Buy An Investment Property

Investing in a property differs from buying a primary residence. Before you purchase an investment property, make sure you meet the requirements.

1. You’re Financially Stable Enough To Cover Costs

Financing for investment properties requires a healthier financial profile than for primary residences, particularly if you plan to rent the property to tenants. Here are some costs you’ll need to cover when buying an investment property:

Mortgage Payments

Before taking out a mortgage to finance your investment property, make sure you can afford the monthly mortgage payments. If you’re renting, you should aim to make at least enough rental income to cover your monthly mortgage payment. If the property is vacant or you can’t rent it for as much as you wanted, you’ll need cash reserves to cover the cash shortfall and make your monthly mortgage payments.

Down Payment

Most mortgage lenders require borrowers to make at least a 15% down payment for investment properties. What you put down will depend on your lender and the loan type. For instance, if you take out a conventional mortgage, you’ll likely make a 15% – 25% down payment.

Initial Property Purchase Costs

Before purchasing an investment property, make sure there’s enough money in your budget to cover the initial purchase costs, such as a home inspection and closing costs. In many states, investment property owners are legally required to inspect and clean their properties.

Property Maintenance Costs

As a landlord or rental property owner, you must complete essential repairs – like emergency plumbing or HVAC issues – which can cost a lot of money. Check your local government’s building codes to ensure your repairs meet their standards.

It may be wise to budget more money than you think you need for routine and emergency repairs.

Tenant Costs

Investment property expenses don’t begin when tenants move in or when you purchase a property with tenants. You’ll need to budget money to advertise the property and run credit and background checks on potential tenants. Great tenants are an asset. Difficult tenants are challenging to deal with and can dramatically increase your expenses.

2. The Return On Investment (ROI) Is There

In today’s market, real estate investors often see positive cash flow with their investment properties, and the savviest investors calculate their approximate return on investment (ROI) before purchasing a property.

To calculate your ROI on a potential property investment, follow the steps outlined below.

Estimate Your Annual Rental Income

Look up similar rental properties in your area. Find the average monthly rent for the type of property you’re interested in and multiply it by 12 to calculate income for 1 year.

Calculate Your Net Operating Income

After estimating your annual rental income, calculate your net operating income (NOI). Your NOI is your estimated annual rental income minus your annual operating expenses. Operating expenses are the total amount you pay to own the property each year.

Your expenses can include:

• Homeowners insurance
• Property taxes
• Maintenance
• Homeowners association (HOA) fees

Subtract your operating expenses from your estimated annual rental income to find your NOI.

Calculate Your ROI

Divide your NOI by the total value of your mortgage to calculate your total ROI. Your ROI can help you determine whether you should invest in a property. It can also give you an idea of a real estate investment’s profitability.

ROI Example Calculation

Suppose you buy a $200,000 property that you rent out for $1,000 a month. Your total potential annual income is $1,000 multiplied by 12 months, which equals $12,000. Let’s also assume you pay about $500 a month in maintenance fees and taxes. To calculate your estimated operating expenses, use the following formula:

$500 ✕ 12 = $6,000

Next, subtract your operating expenses from your total potential rental income to get your net operating income.

$12,000 − $6,000 = $6,000

Finally, divide your NOI by the total value of your mortgage to calculate the property’s return on investment.

$6,000 ∕ $200,000 = 0.03, or 3% ROI

A 3% ROI is excellent if you can buy a property in a promising area and know you can rent to reliable tenants. If the area is known for having short-term tenants, a 3% ROI may not be worth the time and effort.

3. You Have Time To Manage It

Investment property management can take up a lot of time. Here are a few tasks you may be responsible for when you purchase an investment property:

• Posting ads to attract potential tenants
• Interviewing potential tenants
• Running background checks on tenants
• Ensuring tenants pay their rent on time
• Performing maintenance on the property
• Making timely repairs when anything in the home stops working

You must maintain the home while maintaining your tenant’s right to privacy. In most states, landlords must give tenants at least 24 hours' notice before they drop by.

Before buying an investment property, make sure you have plenty of time to maintain and supervise the property.

Applying For Investment Property Loans: How To Prepare

Mortgages and loans for investment properties – such as non-owner-occupied mortgages – work differently from mortgages for residential properties. To help streamline the application process, prepare as much as you can before applying for a mortgage loan on an investment property.

1. Check Investment Property Loan Requirements

Investment property mortgages typically have stricter requirements than mortgages for primary residences due to the higher risk of default and foreclosure.

When applying for a fixed-rate mortgage on an investment property, most lenders require:

• At least a 15% down payment
• At least a 620 credit score (Rocket Mortgage^® requires a credit score of 620 or higher)

To help secure a competitive mortgage rate, try raising your credit score, lowering your debt-to-income ratio (DTI) or making a larger down payment on the property.

2. Collect The Necessary Paperwork

When you apply for a mortgage preapproval, you must provide basic personal information. Most mortgage lenders require:

• 2 years of tax returns
• 2 years of W-2s
• 2 months of recent bank statements and other investment account statements
• A list of your monthly debts to determine debt-to-income ratio
• Recent pay stubs

Lenders review these documents to confirm a steady income and verify you have enough money to cover your monthly mortgage payments.

3. Secure Mortgage Preapproval

To know how much home you can afford, get preapproved for a mortgage before you start looking at properties.

Preapproval Vs. Prequalification

A preapproval or initial mortgage approval is different from prequalification. With prequalification, a lender tells you how much money you can borrow based on your unverified, self-reported information. With preapproval, a lender verifies the financial information you submit, so the estimated loan amount is more likely to be accurate.

Mortgage prequalification is a less formal review of your credit, income and assets. Preapproval is an extensive process that includes a hard credit pull and requires proof of income and assets.

The Bottom Line: Owning An Investment Property Requires Planning And Preparation

If you’re thinking about buying an investment property, start by assessing your financial stability and the property’s potential to turn a profit. Decide whether you can manage the property yourself or need to hire a property manager. Finally, evaluate the housing market, property taxes and other costs of managing a rental property.

When you’re ready to buy an investment property, the next step is to get your financing in order. Start your mortgage application to take the next step in securing an investment property.