What to Know About Buying an Investment Property

A well-diversified portfolio is a basic investing principle. One of the best ways to achieve diversification outside of the stock market is by adding real estate to your portfolio through an investment property.

An investment property is physical real estate that’s purchased to generate revenue either through appreciation or monthly rent payments. Investment properties can include residential, commercial, and mixed-use properties, as well as raw land.

We explore what you need to know before you buy an investment property.

Types of investment properties

As mentioned, there are many types of real estate investments. Here are a few of the most common:

Residential

Residential investment properties, which include single-family homes, multi-family homes, and entire apartment buildings, are the most common way investors make passive income through real estate. A short-term strategy is to “flip” a property, which involves buying a home, making improvements to increase its value, and quickly selling it for a profit. A longer-term investment strategy is to purchase one or more rental properties. The owner rents out the unit(s) and collects monthly rent payments from each tenant.

Commercial

Investors can also choose to purchase commercial real estate, which includes properties used for business purposes. These include office buildings, shopping malls, and warehouses. Commercial properties are generally more expensive and require a much higher initial investment.

Maintenance and improvement costs can also be very costly, but they tend to command higher rents, which offset the costs.

Mixed use

A mixed-use investment property can be used for both commercial and residential purposes. For example, it could be a building with a grocery store or retail shopping area on the bottom level and apartment units on the floors above.

Raw land

Raw land is undeveloped land that could be zoned for residential or commercial use. Many investors will purchase raw land in the hopes of later selling it to a developer at a profit.

Farmland is also a popular asset for real estate investors. It’s typically held over the long term—investors can earn income by leasing the land to farmers and capital appreciation in the future when they sell the land. Farmland also tends to have a low correlation to the stock market, making it a valuable diversification play.

What do I need to buy an investment property?

If you’re planning to purchase an investment property, there are several things to consider before you move forward.

Down payment

Purchasing an investment property typically requires a significant down payment. Many lenders require investors to put at least 20-25% down. However, some lenders may be willing to work with as little as 15% down. The requirement will usually depend on the investor's risk profile.

Because the property isn’t the investor's primary residence, there is a higher chance they could walk away if the investment isn’t profitable. By requiring a higher down payment, the lender reduces the risk of default by spreading the risk to the borrower.

Good credit score

As with a mortgage on a principal residence, lenders want real estate investors to have a good credit score in order to lend money for an investment property. This shows that the investor is responsible, and the likelihood of them making timely payments is higher. Investors with a lower credit score can still get approved for a loan, but it will usually mean a higher interest rate.

Cash reserves

Before purchasing an investment property, it’s important to have a cash reserve available. This will cover unexpected expenses, like a new water heater or refrigerator. It will also help cover the fixed costs when you have a vacancy to fill.

The exact amount you should have depends on the property's age. Older buildings will typically have more issues than newer ones. Ideally, you’ll want to be able to cover three to six months of your fixed expenses. Many investors will set aside a percentage of the monthly cash flow to build their cash reserve account.

Will you use a property manager?

When purchasing a rental property, you’ll want to decide whether you will use a property manager. A property manager would find tenants, collect rent, and handle any property maintenance needs. You can do this work yourself or hire someone to do it for you. The first option would cost you time, but the second would be an added expense.

Average market rents

Before purchasing an investment property, you must understand the area you are buying in and the average rent per bedroom or square foot. This will allow you to calculate the potential return on your investment.

Pros and cons of buying an investment property

Before purchasing an investment property, it’s important to understand the pros and cons to ensure it’s the best investment for your objectives and risk tolerance.

Pros of buying an investment property

Appreciation can lead to a sizable profit: Over the past decade, real estate prices have risen steadily across much of the United States. While there is no guarantee, this price appreciation means that many real estate investors have been able to sell their investments at a significant profit.

You’re building equity with other people's money: When you purchase one or more rental properties, your tenant's monthly rental payments help you build equity—the money isn’t coming out of your own pocket.

Can provide consistent cash flow: As long as tenants in your investment property pay the rent, they’re giving you a consistent flow of income.

Tax advantages: Investing in real estate offers tax advantages. For example, operating expenses are tax deductible. This includes property management costs, repairs and maintenance, and more. You can also depreciate a rental property over a 27.5-year period if certain criteria are met.

Cons of buying an investment property

Real estate is illiquid: A real estate property can’t easily be converted to cash, meaning your money isn’t accessible unless you sell the property or refinance.

You could lose your investment: As with many investments, there is a risk of losing money. For example, property values could decline to a point where the property is worth less than you owe. Or, you could lose your tenants and be left with no rental income to pay the mortgage and other expenses for an extended period.

It’s not a fully passive investment. If you want to invest in real estate but the hassle of buying and managing a physical property seems too much, there are other options. For example, you might want to consider crowdfunded real estate investing platforms, such as RealtyMogul. The popular investing app offers non-accredited investors access to Real Estate Investment Trusts with a $5000 minimum investment.

RealtyMogul

View Offer

RealtyMogul

Fees

1% to 1.25% management fees (additional fees may apply); Income REIT has a 4.5% maximum fee, and Apartment Growth REIT has a 4.75% maximum fee

Min. deposit

$5,000

Higher down payment and interest rates: Most mortgage lenders require larger down payments for investment properties. Plus, the loans often have a higher interest rate than mortgages on primary residences.

What are the mortgage options to acquire an investment property?

Here are some common financing options for investment properties.

Conventional mortgage loans

An investment property mortgage is very similar to a personal mortgage you would use to buy your primary residence. However, because the U.S. government does not back these loans, they usually require a down payment of at least 20%. Keep in mind that most lenders will not consider future rental income when factoring in your debt-to-income ratio. You’ll also need to have a significant cash reserve available.

Hard money loans

A hard money loan can be used to flip an investment property. The requirements to be approved for a hard money loan are significantly less, but they typically have much higher interest rates.

Home equity loans

If you’ve owned your primary residence for several years, there is a chance you’ve built up significant equity. If so, you can consider taking out a home equity loan. These loans allow you to convert the equity from your primary residence into cash, which you can use as a down payment on an investment property.

A home equity lender typically allows you to borrow up to 80% of your home’s value minus the amount you currently owe. Plus, the interest rates are more like those of a conventional mortgage than a hard money loan.

Private loan

Another potential option is to bring in a friend or family member as an investor. They would provide the funding for the property, and in exchange, you would agree on the terms of the loan regarding the payback period and interest rate.

How do investment properties make money?

When you purchase an investment property, there are a few ways that you can make money.

Cash flow

The most common reason people purchase investment properties is for the potential cash flow they can provide. For example, let’s assume you purchase a rental property and collect $2,000 of monthly rent. Your expenses and mortgage payments total $1,700 per month. This scenario would provide you with a $300 net monthly cash flow.

Appreciation

Another way investors can make money is from the appreciation of the home's value over time. According to a CoreLogic report, the average value of a home in the U.S. has more than tripled since 2000. While you’re not going to benefit from price appreciation on a month-to-month basis like you do cash flow, you’ll profit when you sell the property.

Amortization

A third way for investors to make money from real estate is through amortization. Each month you own the property, your mortgage payment covers the accrued interest and pays down the principal balance. Over time, as the balance of your mortgage decreases, your home equity grows, enabling you to profit when you sell the home. Remember that with a rental property, you’re using your tenant's money to build this equity, not your own.

TIME Stamp: Investment properties provide portfolio diversification

Buying an investment property can be a great way to diversify your investment portfolio and earn income. But before you dive in, it’s important to understand everything that goes into being a real estate investor to ensure it’s the right fit for your financial goals and risk tolerance.

Frequently asked questions (FAQs)

What makes a good investment property?

Many factors make for a good investment property, including the property's location and overall condition, cash flow potential, and market trends.

How many investment properties can I own at one time?

You can purchase as many investment properties as you want, as long as you have the resources to do so. Remember that you’ll need the capital for a down payment, and must be able to cover the various property expenses through rent or other means.

Can I refinance a mortgage on an investment property?

Yes, and there are several reasons you might decide to do so. You could use the equity to purchase another investment property. If interest rates have dropped, you could refinance to have lower mortgage payments and increase your monthly cash flow. You could also change the loan terms to shorten your amortization.