TL;DR
- A rental property is only a good investment if it continues to produce reliable cash flow, even during a slow year.
- Investing in a rental isn’t risk-free. Rental properties are capital-intensive, illiquid, and hands-on, requiring at least some work to get up and running.
- Conventional investment loans typically require 20 to 25% down, plus closing costs and 6 months of savings.
- Run cap rate and cash-on-cash return on conservative numbers to test whether a rental property is a good investment.
Investing in real estate can be lucrative for anyone with the cash to get started. But you may be wondering whether spending your life savings on an income-generating property is a good idea, especially when compared to other investing options like index funds and stocks.
So is a rental property a good investment, or a money pit? The answer depends on a few different factors, including your timeline, investment capital, and location. If you overlook any one of those elements, forget about making a profit; you might end up struggling just to get your money back.
In this article, we’ll dive into ways you can make sure your rental property pays for itself (and might just become your newest source of income). Keep reading to find out how to invest in a profitable rental property, ways to make your taxes work for you, and more.
What is a rental property?
A rental property is real estate bought to earn income. Rather than living in the property, the owner rents it out to tenants, collects rent to cover the mortgage and operating expenses, and keeps whatever’s left as income.
Most new investors start with one of three residential types:
- Single-family rental: A detached house or an apartment leased to a single household. This is the easiest option to finance, sell, and manage.
- Multi-family rental: Duplexes, triplexes, and fourplexes. They generate more rent per building, but having more tenants and more units leads to an increased workload for landlords.
- Short-term rentals: Nightly or weekly stays through platforms like Airbnb. These properties tend to earn more, but require active management and face stricter local rules.
Commercial rental property (office, retail, and industrial) is a whole other ballgame in terms of financing and lease terms, so for the purposes of this guide, we’re only covering residential rentals. Residential is also the easiest place for first-timers to start real estate investing, since it’s fairly straightforward and uncomplicated.
Is a rental property really a good investment?
Whichever type of rental property a buyer picks, appreciation, loan payoff, and taxes can balance each other out, but only when done correctly. You’ll need to keep four things in mind as you determine whether a rental property is a good investment:
- Timeline: After 5 to 10 years, appreciation and loan payoff can outweigh the costs of buying and selling a property.
- Local fundamentals: Population growth, a strong job market, landlord-friendly laws, and a decent rent-to-price ratio are typically more important than a low sticker price.
- Available capital: Lenders typically ask for a 20 to 25% down payment, plus a 6-month reserve that can see you through a slow month or two.
- Management load: Calculate how much time you’d spend fielding tenants’ calls and dealing with property maintenance, or determine how much you’d have to pay a property manager or landlord software to do it for you.
Of these four, the timeline is perhaps the most important. No matter where or when you buy, it takes a significant amount of time and effort to make money on a rental property, and you’ll more than likely have to weather a few low-income months along the way.
So, if you’re looking for an easy, get-rich-quick scheme, rental property investment might not be for you.
The Pros and Cons of Rental Property Investment
Needless to say, investing in a rental property isn’t a decision you can make on a whim. You’ll need to weigh the good and the bad of earning rental property income to determine whether to go all in or hold off and put your money somewhere else.
Pros
Rental properties are a good investment for anyone with the capital, the timeline, and the wherewithal to manage them. The benefits of real estate investing include:
- Semi-passive income: Rent covers the mortgage and costs, plus a profit for savvy landlords, though you’ll likely have to put in some sweat equity to see the returns.
- Appreciation: Over the long term, home values have risen roughly 3 to 5% per year, per the FHFA House Price Index.
- Tax advantages: Depreciation and other operating deductions reduce your taxable rental income, often well below your actual earnings.
- Inflation hedge: Rents tend to rise, but a fixed-rate mortgage payment will remain the same, lowering your costs as the years pass.
- Improved savings: Every rent payment helps reduce your loan amount, so you can build equity even in a difficult market.
Cons
Before you get too excited, you’ll also have to think about the negative aspects of rental property investment. First-time investors often get blindsided by:
- Capital intensity: Between the down payment, closing costs, and reserves, buying property often ties up $50,000 to $100,000 (or more).
- Illiquidity: Selling a rental typically takes at least a few months, so if you need cash quickly, you’ll have a hard time accessing it right away.
- Tenant and vacancy risk: Periods of vacancy or tenants falling behind on rent will strain your savings, since you’ll have to continue paying the mortgage out of pocket.
- Maintenance surprises: Fixing an unexpected broken HVAC unit or leaky pipe can cost even more on top of your mortgage and regular operating costs.
- Market and regulatory shifts: Home values may drop over time, and rent control or new eviction rules can alter your income with little warning.
While not always a downside, there’s also rental property insurance to think about. Properties in hazard zones, like floodplains or fire-prone areas, may come with higher insurance costs that eat into your bottom line (if you can insure the property at all, that is).
However, that’s not to say you shouldn’t buy a rental property. Risk is part and parcel of any investment, and smart market selection, well-funded reserves, and an honest analysis will help reduce those risks.
The Tax Benefits of Owning a Rental Property
For potential investors, taxes also help make a rental property a good investment, softening the blow of buying one. The write-offs can be large enough that a profitable unit actually shows a loss on paper and reduces your overall tax burden.
Owners can offset most rental income with a long list of rental property tax deductions. Depreciation leads the list, since all structures and appliances on a property depreciate over 27.5 years. Essentially, a $275,000 structure yields about $10,000 a year in non-cash deductions.
Next are operating deductions, which include:
- Mortgage interest,
- Repairs,
- Insurance,
- Management fees, and
- Landlord-paid utilities.
You’ll need to subtract these costs from rental income in the year you pay them.
Additionally, a 1031 exchange can help you defer capital gains if you spend the proceeds from a property sale on another like-kind property within a certain timeframe.
All these benefits come with a caveat, though: the IRS recaptures depreciation at the time of a property sale, meaning you’re not avoiding tax payments, but simply putting them off. You should also confirm the specifics of rental property taxes in your area with a professional.
How to Invest in a Rental Property (Step by Step)
Knowing exactly how to invest in a rental property will greatly improve your chances of profitability, but if you try to skip ahead, you could just as easily lose money. Get started the right way with these eight steps:
Step 1: Set Clear Criteria
Before you start looking, decide on your target monthly cash flow, desired property type, and the maximum price you’re willing to pay for your first rental property. Write that information down and stick to it. Otherwise, you might end up jumping on a mediocre deal that you’ll regret down the road.
Step 2: Build Your Financial Base
Next, you’ll need to figure out whether you’re even ready to buy property in the first place. Tally up how much you have for a down payment, your amount in reserve, and pre-existing debts. Add your credit score to the mix, too. Without strong finances, you won’t even be able to make an offer (much less complete a purchase).
Step 3: Choose the Right Market
Population growth, job diversity, and rent-to-price ratios separate the right market from an affordable one (yes, there’s a difference). Also consider local landlord laws when brainstorming, since licensing rules, rent regulation, deposit limits, and eviction timelines all affect the cost of running a rental unit.
Step 4: Get Pre-Approved
While it might be tempting to jump right into open houses and tours, get your hands on a mortgage pre-approval letter (or several) first. Compare real offers from several lenders, since rates, points, and reserve requirements vary, then confirm what your pre-approval actually supports.
Don’t be too surprised if you can’t afford as much property as you expected. Investment-property terms commonly come with higher interest rates and require a larger down payment than a typical, owner-occupied property.
Step 5: Build a Team
After picking your lender, line up an investor-friendly agent, an attorney, an inspector, and a contractor. Having these contacts on hand while you look at properties will keep you from rushing to find a reliable team at the eleventh hour.
Step 6: Find and Analyze Deals
Once you find a promising property, run through the same four numbers as you analyze it:
- Gross rent
- Realistic operating expenses
- Debt service
- Whatever cash you have left on hand
It can be tough to locate a rental for sale where all the numbers add up, so if you put 30 deals under a microscope and only make one offer, you’re doing it right.
You should also think about a property’s cap rate, which shows how much it earns each year compared to what it costs to buy. Divide the yearly income left after expenses by the property’s price, and you get a percent. A higher number means more returns, but usually more risk, too.
Step 7: Offer, Inspect, and Close
This step of the sequence proceeds mostly like a typical home purchase. When you’re ready to buy a property, you’ll need to negotiate the price, complete inspections, lock in your financing, and sign. Remember to stick to your criteria here: an inspection that turns up a sagging roof or a cracked foundation is grounds to talk down the price or walk away altogether.
Step 8: Place a Tenant and Set Up Management
If you’ve ever been a renter or done any research into becoming a landlord, you should know the drill. Advertise your new rental, screen tenants thoroughly, sign a lease that complies with state law, and store all documents to create a detailed paper trail.
If you find you need a little help (as most first-time landlords do), rental property management software combines rent, maintenance, property management accounting, and much more, all in one place.
Active vs. Passive Real Estate Investing
Not every investor wants to deal with 2 a.m. calls about burst pipes. Fortunately, structures exist to hand off some or all of the daily management duties.
Direct ownership means buying and managing the property outright, which brings maximum control and the full tax benefits. It’s active work, however, not passive income.
For a more hands-off stance, landlords can pass daily operations to a third-party property manager in exchange for a portion of the collected rent. Some turnkey rentals may even already have property managers in place.
You can also join a syndication to pool money with other investors as a passive partner (typically $25,000 to $50,000 to get started). Meanwhile, Real Estate Investment Trusts (REITs) let an investor buy shares in a portfolio of properties, staying fully liquid and passive.
To get started, you’ll need to choose the option that matches your desired workload-profit balance. Do you want to keep all of your earnings, but have to handle the day-to-day demands of rental property ownership? Or would you rather invest in a rental as a passive partner?
The choice is yours, and it shouldn’t be taken lightly.
Make Your First Rental Pay Off
Whichever structure fits, you might still be wondering: Is a rental property a good investment? If you have the money, time to wait for appreciation, and the ability to weather a dry spell, a rental can be a strong move. If the deal only works out under perfect conditions, keep looking.
Investing in a rental property is only the beginning, though. To keep the cash flowing, you’ll need to stay on top of maintenance, handle tenant placement, collect rent on time every month, and much, much more.
TenantCloud can help. Our property management software allows landlords to take care of rent collection, tenant screening, maintenance requests, accounting, and more (all through a single dashboard).
Start a free 14-day trial today to set up your investment property before the first tenant moves in.
Frequently Asked Questions
Is a rental property a good investment for beginners?
Often, yes, though whether a rental property is a good investment depends on four factors. Consider your available capital, willingness to share a building, management capacity, and whether the numbers actually work out over time. Overpaying and rushing into a purchase can lead to poor returns.
How much money do I need to invest in a rental property?
The exact amount will vary by property type, but you should plan for the down payment, closing costs, and a 6-month reserve. Conventional investment-property loans typically require buyers to put 20 to 25% down, while owner-occupied house hacking terms are lower.
How do I invest in a rental property with little money down?
House hacking using an owner-occupant loan sharply reduces the down payment, since owner-occupied financing carries better terms than investment financing. Beyond financing, partnering with another investor lets you invest with less capital. Sure, no-money-down deals exist, but they’re rare and risky.
What is a good cap rate for a rental property?
A cap rate is the yearly income a rental earns after expenses, divided by its price, shown as a percent. Most rentals have cap rates between 4 and 10%, and investors often look for 5 to 8%, though the right number depends on the market and your risk tolerance.
