RReal estate can be an extremely powerful way to build wealth and generate passive income, but not all rental property is a good investment. In fact, there are several scenarios where buying a rental property can put you in a worse position later.
To help you avoid an unnecessary headache or getting stuck in a money pit, here are three reasons why rental property is a bad investment and tips on how to avoid those scenarios.
1. Little to no cash flow
Rental property is an investment to consider for the potential income it can generate today and in the future. Many investors attach great importance to the possible increase in value of a rental property – i.e. the increase in value of the property over time. But appreciation is not guaranteed. Markets change, and there’s always a chance that the home will be worth less when it comes time to sell it.
Cash flow should also be considered when assessing the potential of a rental property. Rather than simply hoping for enough rental income to cover the property’s expenses and maintenance over time, try to achieve positive cash flow — the higher the cash flow, the safer it is.
A property that generates residual income of $100 or less doesn’t leave much room to maneuver when the market turns and rents plummet, the tenant defaults and you have to evict, or you’re hit with an expensive repair. If you focus on cash flow first, you’re guaranteed to make money today, but hopefully well into the future.
2. Investing in the wrong area
Rental markets are highly localized, with unique supply and demand for each zip code, county and neighborhood. The quality of the tenants, the safety of the neighborhood and the level of demand for rental properties in that area determine whether the investment is profitable and passive or an absolute nightmare.
Very affluent areas with expensive real estate prices may check the boxes for security, but not require or return them. Low-income neighborhoods can generate tremendous cash flow but have higher crime rates or higher tenant turnover. Striking the happy medium between affordability, security and stable rental demand is the ultimate goal for buying rental property in any market.
While the neighborhood and price of the property can have an impact, understanding how to screen and record tenants is also extremely important. Conduct a rigorous screening process that looks at the full picture of the renter, not just their credit score or income, and always follow federal and local laws on renter screening. Poor tenant underwriting can result in a tenant nightmare no matter where your property is located.
3. The rent overwhelms you
Being overwhelmed in a rental property is not a good position, no matter how lucrative the property may be in the future. It’s important to make sure you start with enough cash for the down payment, which will be around 20% or more, as well as several thousand dollars in savings as a safety net for any unexpected repairs or expenses that might arise while you’re building up capital reserves from the rent .
You should never buy a property without knowing that you can sustain the associated debt obligations with your current income. Economic circumstances can change. Your income can fluctuate, and if the tenant doesn’t pay or the property sits vacant longer than expected, you’re still responsible. If you’re not ready financially, wait until you have more savings and don’t spread yourself thin.
think about it
Rental properties will always be available, with some periods offering more opportunities than others. Be patient and make sure the investment makes sense from all perspectives. Let the numbers guide your decision and make sure you are informed about what to look for and how to assess and avoid risk and you will significantly reduce your risk of making a bad investment.
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