by Nancy Osborne, COO of ERATE®
Many fortunes have been both made and lost in real estate. If you think that investing in real estate is right for you then you'd better have the time and the motivation to devote to it as if it were a business. Learn everything you can about property, valuation, management, tax treatment as well as the local rental markets. Your success in real estate will hinge on how you manage a property's cash flow. You'll need to analyze whether your cash flow will initially be positive or negative, and if it's negative, to determine whether you will be able to support the deficit until it reverses course.
There are basically two sources of income generated from rental properties: rent and appreciation. Both are offset by expenses which come in the form of a mortgage, taxes, insurance and general maintenance. Property management should also be a factor and something you need to be ready for if you intend to do it yourself as this can be both time consuming and irritating. Are you prepared for 2 a.m. calls when the pipes burst? Do you have a solid plan for locating and screening good tenants?
The theory of course is that over time, rents will rise along with a property's value and many of the expenses, which are fixed, will remain constant and will eventually be over shadowed by the income a property produces. Another key factor is the tax treatment of the property, while there are some tax advantages to owning rental properties many have been slowly phased out. Today the so-called passive activity rules require that any losses produced by a property be offset only by income generated from the property. The other primary tax advantage is that of depreciation. Many an over-eager real estate investor enters the world of rental real estate thinking that depreciation write-offs (that is utilizing a percentage of the property value in annual increments) and the resulting tax savings from doing so will put them on the road to profitable real estate investing. However any deductions taken in the way of depreciation must be recaptured at the time the property is sold so essentially you are deferring your taxes rather than realizing a true tax savings. This goes back to cash flow and how a dollar saved today could be worth more on a present value basis and may be an acceptable trade off for having to comply with the depreciation recapture rule at the time the property is ultimately sold.
It is important to know before pursuing financing on an investment property that many lenders guidelines will not permit you to use 100% of the rental income on the newly acquired property to offset the mortgage and property expenses. Typically mortgage underwriters are allowed to use only 75% of the monthly rent collected and then they can offset any expenses against the property to arrive at either a positive number which will be added to your income, or if the resulting number is negative, it will be added to your long term debt and included in the debt-to-income ratios used to qualify you for the loan. However if you are refinancing and the investment property has been rented for a period long enough for you to have filed several tax returns with the rental income reflected, then the lender's underwriter will be able to use more rental income and is usually permitted to add back any depreciation taken into the total thereby enhancing the amount of income received from the property to offset expenses. Of course other ways to finance property include taking cash out on your primary residence by way of either an equity line of credit or a cash-out refinance to apply towards the purchase of an investment property. Also a potential seller may be willing to do a total or partial carry-back loan to provide you with the financing you need to purchase the home by extending a first or second mortgage.
Before embarking on the path of investing in rental real estate, answer the following questions: 1) Do you have the cash available to meet the down payment requirement? Typical investment property loans require a 20-30% down payment by the lender. 2) Do you have the resources, as well as the time, required to locate the right investment property to meet your needs? 3) Are you willing and able to manage the property after you have acquired it?
Nancy Osborne has had experience in the mortgage business for over 20 years and is a founder of both ERATE, where she is currently the COO and Progressive Capital Funding, where she served as President. She has held real estate licenses in several states and has received both the national Certified Mortgage Consultant and Certified Residential Mortgage Specialist designations. Ms. Osborne is also a primary contributing writer and content developer for ERATE.
"I am addicted to Bloomberg TV" says Nancy.