Rental properties can add an extra stream of income to your retirement portfolio. Buying a property or two could provide enough income to allow you to retire sooner. However, you'll need to ensure your rentals will become a steady, positive cash flow throughout your retired life. You don't want a rental property to become a drain on your retirement resources. Here's how to make sure your rental investment will work to your advantage:
1. Understand financing options. Even after the financial crisis, those with good credit and a steady work history can purchase properties that won't be occupied by the owner with a mortgage. However, lending requirements are understandably more strict than they have been in the past. Now, you may need to have 30 percent or more up front for a down payment, not including closing costs. Plus, loan terms may not be quite as favorable as when purchasing a home you plan to occupy.
One option is to buy a home as an owner occupied property and live in it for a year before renting it out. This enables you to qualify for the more favorable terms of an owner occupied property. You can also use this time to fix up the property if need be.
You could also use a portfolio lender. These lenders do not sell the mortgage into the secondary market, but instead keep it as part of their loan portfolio. Since the original lender keeps the loan, it doesn't have to meet the terms imposed by the likes of Fannie Mae or Freddie Mac. If you're not familiar with portfolio lenders in your area, ask a realtor with significant experience buying and selling rental properties.
In some areas of the country, you can still purchase a home through foreclosures or tax sales. The rental homes I own were all U.S. Department of Housing and Urban Development foreclosures. This may put rental properties within your reach without needing a mortgage. However, with these homes, you may need to put significant capital into fixing major and minor issues before the home can be rented.
2. Set money in reserve. If you own your own home, you already know that repair costs tend to crop up at unexpected times. This is why it's essential that you have money in reserve before you buy or begin renting a property. If the water heater goes out or the roof needs to be repaired, you'll need to spend money to get it fixed or replace it. And if the house is currently rented, you can't get away with putting off major repairs for a few weeks or months while you scrape together the cash.
Before you buy a rental, set aside at least six months' worth of rental expenses in reserve. Expenses could include routine maintenance, taxes and insurance, if these costs aren't included in the mortgage. Having this much in reserve ensures you can take care of emergencies as they arrive.
3. Get to know tax implications. Rental properties offer some valuable tax benefits. For example, you can claim depreciation on rental properties (but not the land), reducing your tax burden year by year. Depreciation, along with the interest expense on a mortgage, may enable you to minimize taxes for some time. Keep in mind, however, that you'll have to deal with depreciation recapture down the road when you sell the rental.
In many cases rental properties operate at a tax loss. One of the hidden benefits of being a landlord is that these "losses" can be deducted on your tax returns, up to $25,000 a year. There are some requirements that must be met, and this option phases out for high earners, so be sure you understand the rules.
The tax implications of owning rental properties can be beneficial, but are also complex. Seek out the help and advice of a good tax professional before you decide to launch this type of venture.
4. Choose the right properties. If you choose to make rental income part of your retirement plan, be sure that you purchase the right properties. None of this will work if your property is not a profitable investment because it's in the wrong school district or attracts difficult tenants because of the neighborhood.
When shopping for a rental, always consult an experienced local realtor who has experience with rental properties. This person should be able to tell you how much homes are renting for in a certain area, which parts of town have a high demand for rentals and generally how to find a rental that will generate positive cash flow.
Many experts recommend that first-time landlords focus on single family properties in good school districts. Families with kids may be less likely to break a lease unexpectedly, and they will be looking for a home in an area with good schools. That's been my approach to real estate investing.
Finally, as a general rule of thumb, I look for properties that will rent for an amount equal to 1 percent of my total investment. If a single family home costs $150,000 (including rehab costs), I want to be able to rent it for at least $1,500 a month. If I can't come close to this amount, I don't buy the property. However, the ratio of rent to cost varies significantly based on location.
Rental properties can be a great addition to your retirement portfolio. It can be even better if you like to do home maintenance and are looking for a part-time job in retirement. However, there are plenty of caveats to becoming a landlord. Be sure you understand all the ins and outs of using rental property for retirement income before you buy your first rental home.