The decision to begin investing in real estate is more complicated than the decision to buy a stock or a bond. Real estate investing requires an up-front financial commitment plus ongoing expenses and personal responsibilities that other investments simply don’t require. Before you begin, make sure you understand and can fulfill the financial and personal obligations that real estate investing demands.
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Assess Your Financial Situation
Real estate investing requires a large initial chunk of capital plus an ongoing stream of income for mortgage payments and everyday expenses, such as repairs. To assess whether you’re in a financial situation suited to real estate investing, consider the following factors:
- Monthly cash flow: To determine your cash flow, subtract your monthly expenses from your monthly income. Consider investing in real estate only if your monthly cash flow leaves enough money to cover the expenses and mortgage payments you’ll have to pay for the property you buy. Never invest expecting to cover expenses by borrowing and then eventually paying back your loans by selling your property.
- Debt-to-asset ratio: Calculate your debt-to-asset ratio by dividing your total liabilities by your total assets. Ideally your debt-to-asset ratio should be less than 1. If it’s considerably higher than 1, you likely have too much debt to invest in real estate.
- Available capital: In addition to the monthly cash flow required to pay for mortgages and expenses, you’ll also need a lump sum for the down payment on a property, ideally 20% of the purchase price. Though some investors make a smaller down payment, it’s best to limit your investing to properties for which you can pay at least a 20% down payment from your own savings, or from a pool of money assembled by partners with whom you’re investing, such as friends or family members.
- Time horizon: Your time horizon is the amount of time you expect to own an investment before selling it. Real estate investing works best for investors with time horizons of at least 5–7 years, and preferably more. Before buying any investment property, be sure you’ll have the money required to hold the investment—and pay for the costs it generates—for at least 5–7 years.
Consider the Expenses Involved
In addition to the down payment and mortgage costs, as a real estate investor you must also consider the following recurring expenses:
- Management fees: Unless you manage your property yourself, you’ll have to hire a property manager to do bookkeeping, routine maintenance, and deal with tenants. Most property managers charge roughly 10–15% of the monthly rent you charge your tenants.
- Repairs: You’ll most likely encounter problems with your property that you can’t fix on your own, such as plumbing or electrical problems. In these instances, you’ll need professional repair service, which can cost $50 per hour or more. It’s a good idea to set aside $25 or so each month for a repair fund—eventually you’ll need to use it.
- Property taxes: Though you can usually deduct property taxes on your federal income tax return, you still need to have the money available to pay your tax bill during the year—most municipalities collect property tax payments several times per year. Though exact amounts vary from city to city, expect to pay at least 1% of the initial purchase price per year in property tax. Lenders often link escrow accounts with mortgages in order to bundle property tax payments in with mortgage payments—that way you pay off your property tax bill and your mortgage at once.
- Condo and co-op fees: Condos and co-op owners must pay monthly dues for property maintenance and other shared expenses. These dues vary widely but usually add up to at least $100 per month, or considerably more in some cities.
Consider the Personal Responsibilities
Owning and managing property can have a fairly significant impact on your lifestyle. Be sure to consider these factors before becoming a real estate investor:
- Your location: The closer you live to your investment property, the easier it’ll be to fill vacancies, make repairs, and collect rent. If you live beyond driving distance from your investment property, you’ll most likely need to hire a property manager.
- Your personality: Although ideally you’ll choose reliable and respectful tenants, you’ll inevitably encounter problems, such as late rent payments or damaged property. Resolving these situations often requires acting in a firm and forthright manner, which can range from demanding the rent to evicting your tenants. If you’re not sure you have the personality to be a landlord, real estate investing may not be for you.
- Your time: Real estate investing requires a substantial amount of time to find, buy, manage, and sell property. Unless you’re passionate about devoting a portion of your life to the pursuit, it’s probably best to stick to lower-maintenance investments, such as stocks.