Is Buying A Rental Property A Good Investment?
Let’s talk about buying a rental investment property and the potential expenses of home ownership that you may incur. Yes, there are advantages to homeownership. However, buying a property as an “investment” is not as clear cut as many seem to think. Do you qualify to refinance your rental property for needed updates? Contact Sun Mortgage Funding and find out!
Many people think owning rental property is a simple, and easy way to make a lot of money. It is much more complicated than that. There are many unexpected and unpredictable expenses that can and will arise. This happens both in the purchase and renovation of an investment property. It also happens in the actual use of the property.
Predictable Expenses of Owning A Home
- Appreciation –
Even though some expenses can be predicted, there is still an element of uncertainty that cannot always be eliminated. For instance, insurance and tax payments are predictable in the sense that they are paid annually and at the same time every year. However, based on insurance claims being paid out or assessment changes from the city government, those payment amounts can sometimes vary widely.
Also, taxes and insurance tend to increase in cost over time. It makes sense that if a property has an increased value, the taxes and insurance for that home would go up as well.
Property Insurance for Coverage –
There are many variables that can affect that insurance amount as well. There are different kinds of insurance that pay you differently based on how the policy values your property. Some policies will use “Replacement Cost” while others will use “Actual Cash Value”.
Replacement Cost policies are usually more expensive. This is because they will pay out however much it costs to rebuild and “replace” the physically damaged house or part thereof with brand new materials, and labor costs. This is a higher figure than what an “Actual Cash Value” policy would pay.
An “Actual Cash Value” (ACV) policy pays for the cost of replacing the damaged premises, but it subtracts out the “depreciation” of the premises. That means, if a roof lasts for 20 years, and it needs to be replaced due to a covered loss after 10 years, the insurance company would pay you ½ of the cost to replace it with a brand new one.
Obviously, this could be a serious amount of money you may have to come out of pocket for this roof replacement. If the new roof installation is $20,000.00 then, in this case, the insurance company would pay you $10,000.00, and you would be responsible for the other $10,000.00. It is clear why this type of policy costs less than a “Replacement Cost” policy.
- Flood Insurance –
What also adds to the list of expenses is flood insurance. Flood insurance is different from property insurance. If a flood occurs and you have only property insurance, you may get nothing from the property insurance company towards your loss.
Flood Insurance can be purchased using replacement cost or actual cash value for the valuation of the lost property. However, it is not a true replacement cost or actual cash value policy. This is because a true replacement cost policy has a guarantee that will replace the total of the damaged property regardless of the coverage amount.
A true actual cash value policy will pay the full depreciated cost of replacement regardless of the coverage amount. Most government flood insurance programs are written on an actual cash value basis. The main difference is that a flood insurance policy will only pay up to the coverage amount.
Most government flood insurance programs have a maximum coverage limit of $250,000.00. An additional policy can be purchased to cover additional amounts if a property is worth more than $250,000.00.
Unpredictable Expenses of Home Ownership
Some costs can be more easily predicted. For instance, when buying a property that has a sales price, you know that while you pay somewhat more or less than the purchase price, the price itself is a pretty good benchmark for what you can expect to pay to purchase the house.
You can also predict and estimate the closing costs of buying the house at a decent level of accuracy. It is usually based on the price but also may depend on any additional legal services or filings that arise. However, some expenses of home ownership can be extremely hard if not impossible to predict.
We refer to these as “unpredictable expenses”. Some of these expenses are, repairs, market fluctuations, default by tenants, vacant property carrying costs, natural disasters, change in law or ordinance, and environmental changes.
- Property Repairs –
Some repairs can be predicted in advance. If you can see that paint is starting to peel or wear away, or if a roof looks like the shingles are not in good shape you can estimate when it will need to be redone or replaced. But some repairs come out of the blue.
A plumbing repair is usually hard to predict and can depend on how the tenant is using the plumbing. Some other unpredictable repairs might be due to appliance or some other kind of installed fixture malfunctioning. If the air conditioner goes out in the summer, that will be not only unpredictable but also would need to be fixed A.S.A.P.
The same situation would occur if a heater or heating element goes out during the winter. Also, some repairs that you think maybe far off can sometimes progress quickly and become imminent. Such as some woodwork that is deteriorating suddenly falling off or becoming dangerous.
- Changes In The Rental Market –
Market fluctuations can also become an immediate cost or expense. Overtime rental amounts usually go up. However, this is not a hard and fast rule. If you are trying to rent a house or unit, and it is sitting vacant for too long, you may need to decrease the rent amount in order to get it occupied.
If you are asking $1200 per month, and you go for two months with no rent, you will have lost $2400 in income. Dropping the asking rent amount to $1100 instead and rent it after one month the overall loss after a year would be $1200.
So, holding out for a higher rental amount isn’t always worth it. This may have absolutely nothing to do with the market though, it could just be a coincidence that it still hasn’t rented. It is impossible to know the exact cause of demand changes for rental properties.
An additional option if it seems like you are not able to get the rent amount your property should be getting is to update parts of or all of a property. Some updates are more costly than others, and you should make sure your updates will translate into increased rental amounts. This would fall into the category of unpredictable expenses of home ownership.
- Tenant Default –
Tenant default is another expense that can be hard to predict. You should try to limit the risk of a tenant defaulting on rent by screening your tenants carefully via verifications of employment, credit reports, and referrals from previous landlords. Even with this, it’s impossible to predict all of the changes that could affect a tenant’s financial health. Just a few things pop into mind; a health problem, a family problem, even a legal problem.
Natural Disasters Are A Great Example of Unpredictable Home Expenses
Damages from natural disasters can also be an unpredictable expense. Who can predict a natural disaster? Nobody! However, you can have a property insured. But not all insurance policies are the same, and yours may not cover “loss of rent”.
You can have that coverage added, but it will cost you to do so by adding to your premium. Even if you do have insurance, there is almost always a part of the loss that is to be paid by the insured. That is usually referred to as a deductible, coinsurance provision, or a retention amount.
- Environmental Changes / Climate Change –
Natural disaster expenses can also be tied to changes in the global environment. We have been seeing over the past 10 years historic amounts of storms, as well as larger more powerful and slower-moving storms.
We have also been seeing a steady increase in sea levels. This changing environmental situation has led to an evolving threat. If we are experiencing more storms and more covered insurance losses than before, we may need to change how we cover our property with insurance.
If you are having more flooding problems, or many more dangerous storms in your area than before, you may need to either increase your coverage amounts or reduce the Deductible amount. These efforts will help to avoid an even bigger loss. Other more costly adjustments can also be made, such as raising a house or adding impact-resistant windows.
Changes In Law Or Ordinance For Home Owners –
The final, in the category of unpredictable expenses of home ownership, is a change in law or ordinance. This means if rules about rental property change it can directly affect your bottom line. For instance, if it turns out that the Federal government changes interest deductions for individual or business income taxes, that could cost or benefit you.
It seems to really depend on the current government and its desires to influence or change policy. You can typically expect a conservative government to reduce taxes, and a liberal government to increase taxes. However, it can depend very much on who has the majority in Congress.
Another change in law or ordinance that has happened nationally but locally as well are the changes in the Air BNB laws. Initially, many people rented full houses out to Air BNB tenants for unlimited periods of time. There are now new laws and penalties locally that make it much more difficult to rent out Air BNB units.
Based on the new rules surrounding Air BNB’s, you could end up falling short of your needed income. Another change in the law that could affect income is film tax credits.
When Louisiana enacted tax credits for films it brought an onslaught of short-term rental business to the city. However, what goes up must come down. Once the tax credits ended, so did the short-term rental business that came with it. If you had planned on that demand being there, it could come as an unpleasant surprise.
In summary, there are an awful lot of potential expenses for home ownership to consider before embarking on a rental property as an investment journey. Make sure you can afford it before setting sail!
If you would like to know if you can afford to buy a particular rental property, use our mortgage calculator.