Rental Properties Can Make Good Investments, but They Come with Risk

Maybe your financial house is in order. Your debt is manageable or paid off. You have an emergency fund and now you're looking for ways to grow your wealth. Or, perhaps you're planning ahead by learning about different investments options. Have you considered becoming a landlord?

Rent prices tend to rise over time, providing an inflation-protected income into your retirement years. You also might be able to cash in big later if the unit's value increases. It doesn't always work out that way, though. Some landlords wind up with a trashed property after evicting a tenant or lose their savings in a natural disaster.

In between the extremes of easy, hands-off income and total ruin are the everyday concerns, benefits and risks that most landlords face.

A few risks you could face as a landlord. Investment property mortgages tend to be a little more difficult and costly to secure than primary residence mortgages. It can also be harder to take cash out of investment properties – either with a cash-out refinance or a home equity line of credit. In other words, you might not have access to the money during an emergency.

Owning a rental property outright can be risky as well. Especially if you're placing a significant amount of your savings in a single investment, the lack of diversification could put you in a precarious situation.

Those aren't the only risks you could face when owning a rental.

• Finding and keeping good tenants. Landlords learn from experience that it's worth leaving their rental empty for a month or two rather than pay for an eviction or expensive repairs later. You can pay for professional tenant screening reports or credit reports and call applicants' references before offering a lease.
• Covering your expenses. Between taxes, insurance, repairs, maintenance and mortgage payments the monthly and one-off costs can quickly stack up. Some landlords lose money because their rental income doesn't cover their expenses, but they won't be able to attract tenants if they raise it. If the housing and rental markets drop, you could be stuck losing money each month or selling the property at a loss.
• The time or cost of managing a rental property. Becoming a landlord is often far from a hands-off job. When the phone rings in the middle of the night because the roof is leaking, you'll need to figure out how to solve the problem. You may be able to hire a property management company to take on this work for you, but they often charge about 8 to 12 percent of your rental income or a flat monthly fee.

Even with the risk involved, there are countless examples of successful landlords. Many find the experience so rewarding that they purchase additional investment properties.

Set yourself up for financial success. What separates the successful and sorrow-filled landlords? Luck certainly comes into play, but you can also take steps to get started on the right foot.

Try to determine a property's capitalization rate, the estimated annual return, before making an offer. To calculate the capitalization rate, divide the annual net income by the property's purchase price.

Your net income will be your rental income, which you can approximate based on rental prices for similar properties, minus your costs, such as maintenance, upgrades, vacancies and emergencies. You may need to consult an accountant to understand how your new tax situation can affect your costs.

Cap rates tend to change depending on the area and type of property. But regardless of what's considered "good" in your area, you can use this formula to compare different investment opportunities.

Bottom line: Many people focus on the positives of owning investment property. An extra income and potential to build equity with their tenants' money seems too good to be true, and it just might be. If you're going to be successful, you should acknowledge the risks that come with the territory and plan accordingly.