How To Know If You Are Ready To Buy Investment Property
October 09, 2017“How do I decide if I’m ready to get into real estate investing?”
I get this question all the time over the Financial Helpline and in one-on-ones with the employees we work with. I also hear it regularly from friends who want to know my perspective on this as a financial planner.
What is interesting about this question is that the answer, surprisingly, has very little to do with the real estate market. And that’s why so many people make bad decisions in this area. They base their decisions on what they think the real estate market is going to do, when instead, they should be looking at their own financial situation to make a decision on this.
The answer has very little to do with the real estate market.
You are a good candidate for investment property if you meet all or most of the following:
1. You have a very stable job and significant cash cushion. Ideally that would be 1 year plus of your living expenses in a liquid account that you can tap into immediately with no or very minimal penalty (aka it’s not in a retirement account).
2. You have excellent credit (generally 750 or above). This important for two reasons:
- To get a better loan rate and
- If you end up having more vacancies or home improvement expenses than you expect, you will have better access to credit to cover these expenses if need be.
3. You are ready, willing and able to be a landlord. Ideally you would enjoy that responsibility and/or you can cover the costs of paying someone to maintain the property like a building super who can address issues that tenants face and ensure the property is properly maintained. This becomes very important when you are ready to sell, not to mention it is your legal obligation as a landlord to maintain the property for tenants.
4. You are looking for a good tax shelter to offset income taxes and capital gains.While all of us want to reduce taxes, investment property can be particularly attractive for those who are in a high-income tax bracket. Some ways you can take advantage of this are through write-offs on such things as mortgage interest, property tax, gardening, property management, etc. You may also be able to write off as much as $25,000 in real estate losses against your total income depending on your adjusted gross income (AGI).
5. You can separate your emotions from the process and buy for purely financial reasons rather than personal preferences. Remember, you won’t be living in this property so whether or not it’s your favorite style of architecture is irrelevant. But whether or not you have a positive cash flow (meaning your rental income exceeds mortgage and other property expenses) is very important. So, you need to be ready to cast aside a love of real estate as an art form and cultivate a love of it as an investment vehicle in order to be financially successful.
Bonus criteria, but not essential
You have a spouse with a stable job. This further reduces risk of a major cash flow problem if you lose your job
You know a lot about real estate and/or have people around you who are experts in real estate and can advise you. Key knowledge areas include:
- home improvements/renovations that are most likely to enhance retail value;
- understanding of rental and vacancy rates in the area you are looking to buy;
- trends in real estate prices and key facts about the neighborhood and how the local economy may impact future housing prices.
Real estate agents can help here, but it’s nice to have people with expertise that you know and trust on your side as well. This is why large real estate investors have teams of people who work for them.
You should not buy investment property if you meet ANY of the following criteria:
1. You are stretching to buy the property, or you have any reason to believe that your job is not secure. If your debt to income ratio begins to exceed 35% after the purchase, then you are stretching. If you do not have a liquid cash cushion (1 year plus of your living expenses is recommended) and would have to tap into your investments to cover a financial emergency (e.g. longer than expected vacancies, roof begins leaking), you are stretching and until you develop this cash cushion, you should not purchase the property.
2. You enjoy a life free of hassle and try to limit your responsibilities. In other words, you don’t want to be tied down. In this case, it doesn’t matter how attractive the deal is, you are not ready to be a landlord and buy an investment property.
3. You have fair or poor credit (below 700). In this case, you may not even qualify for a loan. Or if you do, the interest rate could significantly drive up the cost of the mortgage and make the property a money pit where you are consistently paying more in mortgage than you are getting in rent.
4. You are already heavily invested in real estate relative to other assets. “Heavily invested” meaning 20% or more of your wealth, not including your primary residence, is tied up in real estate. This is particularly important if most or all of your real estate holdings are in one area — if housing prices plummet in that area, you could run into serious financial problems.
One more watch-out
Think twice if you are going to purchase the property with friends or relatives. This is not to say it can’t be done successfully — ironically, I’ve done it myself and it has worked out fine — but the odds are against you here. We were able to make our situation work because we selected partners who were financially responsible and also set up a legal structure to account for contingencies. If you’re skeptical about your potential partners’ financial position, you may want to shy away from the deal or go it alone.
Just the first step
Okay, so after all this, you should have a better handle on whether or not you are a candidate for investment property. But that’s only the first step. It doesn’t mean that the properties you are considering are a good investment. It only means that you are in a good financial position to be able to invest successfully in real estate.
The next step (for those who are good candidates for buying an investment property) is to find the right property. If I had a dollar for every time someone asked me if they should purchase a specific investment property…. well, I’d be able to buy another one myself!
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