If you purchase the right property at the right price and on the right terms, he says, a rental property can produce significantly more income than traditional passive investments.
This article will describe how much you can expect to invest and earn, how to choose a location for your rental property, and problems that might derail your plans if you aren't careful.
How Much Money Do You Need?
If you plan to finance your purchase with a mortgage, you'll need to take action before you retire, says associate broker Janice Leis, who serves the premier residential areas of Philadelphia and South Florida.
Mortgage lending guidelines typically require applicants to be employed and have at least two years of steady employment history in the same occupation.
Lenders also require a substantial down payment, typically 30% or more, if you won't be occupying the property, says John Walters of LeWalt Consulting Groupe in St. Petersburg, Fla.
If you don't have the cash to make such a large down payment, consider using your IRA funds. All equity growth and income from rental receipts will grow inside your IRA tax-free, Walters says. Purchasing the property with funds inside a Roth IRA, on which you've already paid taxes, means all your earnings and equity can grow tax-free forever, he says.
After you've tackled the hurdle of affording the purchase, you need to think about ongoing expenses. Owning residential income property is like owning a principal residence in that there are variable expenses outside the mortgage, says Rob Albertson, a multi-million dollar residential real estate agent with Austin Fine Properties/PLR in Austin, Texas. There are maintenance costs for minor items (like leaky faucets) and major items (like a new roof).
Don't forget about marketing expenses and periods of vacancy and tenant change-over when you won't be earning income. Albertson recommends factoring no higher than a 92% occupancy rate into your calculations, even in a hot rental market. Be conservative in your estimates of expenses and income.
Tax considerations will also play into what you can afford.
"One of the chief benefits associated with rental property is the ability to claim a depreciation deduction on your federal income tax return," Walters says. Depreciation reduces the value of your property each year to approximate wear and tear. It lowers your tax basis so that you pay less tax on the property when you sell it.
First and foremost, discuss the financial feasibility of your plans with a CPA, a real estate attorney and an insurance agent to see how much everything will cost, recommends Leis.
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Choose a Location
Purchasing the least expensive property you can find won't help you earn a return on yourinvestment if you can't find renters and produce cash flow, says Jenny Usaj, managing broker and owner of Usaj Realty in Denver, Colo.
"Ask a trusted local professional what the best area is for the rental market," Usaj says. "While the price might be a bit higher in better areas, the time marketing the property will decrease as well as the time it might sit vacant. If you are unsure where to find rentals, start near downtown or near a college campus. Rental residences often follow employment opportunities."
It's also important to take a look around the neighborhood and purchase a property that reflects the area's current demographic, says Usaj.
"Is the area populated with single adults or families? Will a one-bedroom or three-bedroom residence be more appealing to the renters nearby? Again, be careful not to jump at the best bargain on the market. Make sure the property will appeal to the lifestyle of the area," she says.
What Will You Earn?
"You want to earn at least 8% from the capital invested in the rental, net of all expenses," says John Graves, managing principal of an independent RIA, editor of the "Retirement Journal" and author of "The 7% Solution: You CAN Afford a Comfortable Retirement." Expenses include the mortgage, taxes, insurance, maintenance, a 10% property management fee and a 10% vacancy allowance.
If you invest $100,000 in the property, you want to be earning a net income of $8,000 a year, he says. The reasoning behind the 8% is that it compensates you for the risk and lack of liquidity of your investment. If you or your spouse can work on the property by doing repairs and maintenance and/or managing the property, those costs will decline, he says.
Investment property owners could run into a number of problems, including renters who fail to pay, excessive maintenance costs and difficulty finding tenants, says Cameron Novak, real estate broker and owner of the Homefinding Center in Corona, Calif.
Working with a reputable real estate agent with references to find your investment property is also important, he says. Any loss of capital when you're near retirement age can be devastating.
Many municipalities have imposed drastic inspections and fees on landlords who want to turn owner-occupied properties into rentals, says John Braun, a real-estate attorney with Thomas Law Group in Minneapolis and a seasoned real estate investor. Potential investors should look into this issue before committing to a purchase. They should also be aware that homestead exemptions don't apply to investment properties, which can mean higher property tax bills.
Would-be landlords should evaluate their temperaments before jumping into property ownership. The job requires tolerance of other people's personalities and living habits, Leis says.
You should also think about whether you want to do the required work. You'll often hear real estate ownership referred to as a form of passive income, but that description isn't really accurate.
"Owning residential income property is not a hands-free affair," Albertson says. "If you don't want to manage the property, or can't, as in you live out of town, you will be looking at 8% to 10% of your gross rents going to a management company to cover rent collection and repair requests."
Finally, selecting the right tenants is key.
"The best advice I can give to income property owners is to perform as thorough a tenant screening as possible," says Albertson. "This is not the part of the process to get lazy or just be happy to get a tenant in to pay your bills - this is who you are entrusting with your retirement asset, so you'd better be sure you are not setting yourself up for disaster or numerous headaches."
The Bottom Line
Owning income-producing property can be a viable resource to provide retirement income and leave a legacy to pass on to your beneficiaries, says Walters.
But it's important to have as much knowledge as you can going into the purchase so you have realistic monetary expectations and are able to preserve your nest egg, Albertson notes.