Breaking Down How Much Money You Need to Invest in Real Estate

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Residential real estate investing has the potential to be very profitable. But how much do you need to invest in real estate and generate steady passive income?

Unfortunately, the perceived excessive costs involved in purchasing real estate can intimidate aspiring residential real estate investors. However, understanding all the costs of buying a real estate investment property will help you avoid costly mistakes.

Buying a rental property, holiday home, or property to flip can yield short-term and long-term financial gains. However, the money needed to start real estate investing depends on several factors. You must establish a contingency fund, pay closing costs, and save for the down payment. Then you have ongoing costs like mortgage payments, property maintenance, and property taxes.

This article provides a thorough overview of how much money you need to start your real estate investor journey. You will also get helpful advice on calculating the potential return on investment (ROI).

But suppose you decide against purchasing an investment property. If so, you will learn about additional real estate investing options.

Initial Costs to Consider

Before buying your first rental property or house flipping project, it is crucial to think beyond property prices. Purchasing property requires a considerable amount of cash upfront.

Down payment

The down payment is one of the biggest upfront costs when buying real estate. Typically, you can expect to make a down payment of between 15% and 25% of the purchase price.

But the size of the down payment depends on several factors. These include the following:

• Type of loan
• Your credit history
• Type of mortgage
• Debt-to-income (DTI) ratio
• Loan-to-value (LTV) ratio
• The property type

Even if you have enough for the down payment, your lenders will require you to meet certain criteria before approving a home loan. The criteria include:

• A minimum credit score of 700: You need a minimum credit score of 700 unless you are willing to pay more than 25% of the sale price upfront. But to qualify for the best mortgage rates, your score must be at least 740.
• A minimum loan-to-value ratio of 80%: Generally, lenders will loan up to 80% of the total loan amount. However, the amount differs depending on the property type and lender.
• A minimum debt-to-income ratio of 45%: Real estate investors typically cannot allow their monthly debt to exceed 45% of their gross monthly income.

In addition to the initial cost of the down payment, remember that it can affect your ongoing costs. For example, making a larger down payment can help you lock in lower interest rates. Over the home loan term, this can significantly reduce your mortgage payments.

Closing costs

Real estate investors must pay most of the closing fees when finalizing a mortgage and real estate sale. Typically, you can expect to pay between 3% and 6% of the sale price in closing costs. These fees include charges for appraisals, inspections, title insurance, legal fees, lender fees, and various additional fees.

Here is a list of some of the fees you can expect to pay in addition to the money upfront when investing in real estate:

• Loan origination fee: This is the lender’s fee for processing the loan application. This cost is typically 0.5% to 1% of the loan amount.
• Title search and title insurance: The lender carries out checks to ensure no issues with the property’s title, like a tax lien. Title insurance protects the lenders in case issues with ownership arise after the sale.
• Underwriting fee: This is for processing the cost of verifying the borrower’s credit history, income, and other financial information.
• Discount points: Many investors pay more money upfront to buy discount points and reduce the mortgage interest rate. One discount point equals one point of the mortgage’s interest rate.

Other fees you may have to pay at closing include attorney fees, recording fees, escrow fees, and courier fees. Also, you may be required to pay homeowner’s insurance and prorated property taxes for the remaining year.

Inspection/appraisal

Like buying residential properties, investment properties are subject to inspections and appraisals. Costs for the appraisal and inspection can be up to $400 each. Not all property purchases require an inspection. However, many real estate investors use the inspection to determine if the property is a good investment.

Here’s more information about these two steps:

• Home appraisal: Mortgage lenders require a home appraisal to ensure the sale price represents its current market value. The appraiser looks at the sale price of comparable properties, the size of the property, and other factors that may affect its value.
• Home inspection: A home inspection is a comprehensive evaluation of the property’s condition. The inspector checks the plumbing and electrical systems, the roof, the foundation, the HVAC system, and the general structural condition. Although not required, spending a few hundred dollars can help you discover hidden repair issues.

Contingency fund

A mortgage lender typically requires you to have significant cash reserves before buying a residential rental property. A contingency fund protects your finances if you have cash flow issues and cannot pay the mortgage. Common cash flow issues in real estate arise from vacancies, unexpected repairs, or market downturns.

Typically, lenders require individual investors to have at least six months of mortgage reserves. Examples of liquid assets that can be used for a contingency fund include:

• Cash in a bank or savings account
• Stock or bond investments
• Cash value of an insurance deposit
• Money in a 401K, IRA, or other retirement savings account
• Certificates of deposit

Let’s say your monthly payment for a mortgage is $1,500. In that case, you would need liquid assets of at least $9,000 to secure a mortgage.

Calculating How Much You Need to Begin Investing in Real Estate

Let’s do the math to calculate how much money you would need to buy a residential rental property as an investment. Assuming the property’s value is $280,000, here is a breakdown of the approximate upfront costs to buy residential real estate:

• Down payment at 25%: $70,000
• Closing costs at 5%: $14,000
• Home inspection and appraisal: $800
• Contingency fund based on a monthly mortgage payment of $1,300: $7,800

Therefore, to get started in real estate investing, you would need around $92,000. Of course, the final amount depends on additional factors like credit scores, DTI, LTV, and current interest rates.

Check out BiggerPockets’ Rental Property Calculator to see if you can afford the investment.

Financing Options

Financing most real estate investments requires a loan or mortgage. Most startup investors use a conventional mortgage to buy their first investment property. However, other options are available, and they can affect initial costs.

Let’s compare various financing options to see how they can affect your financial goals.

Traditional mortgage

A conventional mortgage from a bank or credit union has moderate closing costs, reasonable interest rates, and lower monthly payments. However, you typically need to put down a lot of money upfront.

Hard money loan

Compared to a traditional mortgage, a hard money loan has a lower down payment—sometimes as low as 10% of the loan amount. They are typically short-term loans for fix-and-flip projects. Hard money loans involve interest-only payments with a balloon payment at the end. However, they have higher interest rates.

Partnerships

Partnerships allow investors to make larger real estate investments. They involve collaborating with other investors to manage an investment property. In most cases, partnerships are most effective for seasoned investors.

Therefore, a conventional or private loan is safer than forming a partnership if you plan to purchase a single-family home.

Private money loan

Borrowing money from private money lenders is another option to buy a rehab or rental property. Private money loans can be from private companies, money lenders, family members, or friends. This type of loan can have flexible terms and few upfront costs.

However, a private money loan is a high-risk financing option because it’s unregulated. They may have exceptionally high interest rates and short repayment periods.

Ongoing Costs to Consider

Real estate investing can allow you to enjoy passive income from rental properties. At the same time, you benefit from price appreciation on your investment properties. However, budging for ongoing costs is vital for making the best investment decisions.

Some real estate investors set aside 50% of their rental income for taxes, insurance, repairs, and maintenance costs. Others follow the 1% rule, calculating annual maintenance costs at 1% of the property value.

Property management

Hiring a property manager can help to eliminate the stress of residential real estate investing. The property manager can be on call 24/7 and conducts most of the day-to-day tasks of managing a rental property.

You can expect to pay between 8% and 10% of the gross rental income for single-family homes. You may have to pay additional fees for maintenance, vacancies, evictions, and lease renewals.

Property taxes and insurance

Real estate taxes are ongoing expenses for rental property owners. Additionally, a lender may require you to take out homeowners and landlord insurance. The amount you pay in taxes and insurance depends on the rental property value.

The good news is that owning rental properties has many tax benefits. You can write off taxes, property insurance, mortgage interest, and property management fees.

Mortgage

The property must generate enough rental income to cover the mortgage payment. The monthly mortgage payment amount depends on paying the principal, interest rates, and loan terms. Therefore, if you have a variable interest rate mortgage, you must budget for fluctuations in the financial market.

Maintenance & repairs

Budgeting maintenance costs is vital to maintaining healthy cash flow. Your budget should deal with preventative or regular maintenance and emergency repairs. As a rule, set aside 1% of the unit’s value for annual maintenance. However, you should always budget for a worst-case scenario to maintain positive cash flow.

Vacancy costs

The cost of vacancies can significantly impact your cash flow. Vacancies mean a loss of income and increased expenses. For example, you must search for new suitable tenants and continue to make monthly loan payments. Therefore, you should budget 5% to 10% of the annual rent to allow for vacancies.

Why Is ROI Important?

Calculating the return on investment (ROI) is the only way to make worthwhile investment decisions. ROI factors in rental income, operating expenses, real estate market health, and property appreciation to assess the potential return. You can then determine if the property is worth the investment. A positive ROI ensures the investment helps you build wealth and minimizes financial risk.

How to Determine if You Can Afford to Invest in Real Estate

Calculating how much you need to invest in real estate is more than covering the upfront costs. You must also calculate the property’s potential to generate income.

Let’s look briefly at several methods professional property investors use to look for good opportunities.

The 1% rule in real estate investing

The 1% rule in real estate says that a rental property’s monthly rental income should ideally be at least 1% of its total purchase price. This rule can determine cash flow to see if the property has the potential to be a lucrative deal. It can also help set the monthly rent price for unoccupied properties.

Gross rent multiplier (GRM)

The gross rent multiplier is the purchase price divided by the gross annual rent. This metric is useful when buying a rental property, as you can calculate how long it takes to pay off the investment. You can use it to compare comparable properties to see which one is the better real estate investment.

70% rule

The 70% rule is useful in house flipping to find profitable investments. This guideline means you should not pay more than 70% of a property's after-repair value (ARV) minus renovation costs. This percentage helps maintain a buffer for unexpected expenses and maximizes the chances of a profitable resale.

Use Leveraging to Your Advantage

Leveraging can turn a little money into healthy cash flow and increase the potential for returns. Leveraging requires finding the best mortgage deals and searching for the right property with positive cash flow and appreciation potential.

A simple example of leveraging is to use as little money as possible on a down payment. This way, you conserve your cash for other investments. Or you could use the equity in your existing property to fund a down payment.

However, becoming more experienced in real estate investing is best before using leveraging to maximize gains.

Alternative Options (Less Investment Required)

Suppose you want to start investing in real estate but don’t have enough cash. In that case, several options are available to budding investors without paying huge upfront costs. Additionally, you can enjoy passive income without the headaches of being a landlord.

REITs

Real estate investment trusts (REITs) offer an uncomplicated way to invest in real estate without directly buying properties, reducing risk. REITs own and operate income-producing real estate and pass on profits to investors. Real estate investment trusts are a relatively low-cost, less-complex entry point if you are new to investing in real estate.

For example, Streitwise is a real estate investment trust (REIT) for accredited and nonaccredited investors. You can start real estate investing from $5,000, with a minimum hold time of five years.

Pooled funds

Pooled funds such as crowdfunding projects and pooled REITs offer investing opportunities without huge upfront costs. You purchase shares in the investment portfolio by investing in trusts and partnerships. These investments allow for greater flexibility, diversification, and tax benefits.

Two examples of pooled fund investing platforms are Concreit and Fundrise. These platforms allow you to start investing with minimal upfront costs.

Secured loans

Secured loans are ideal for short-term investing in real estate. The cash you invest gets pooled into crowdfunding real estate platforms. In essence, you help to fund loans to investors. It is possible to select the loans you prefer.

Secured loans offer excellent short-term gains. However, there is no long-term appreciation.

Groundfloor is one of the most common secured loan platforms. You can start with a minimal investment of as little as $10.

Fractional ownership

Fractional ownership is where you join other investors to purchase a property. Partial ownership gives you a stake in the real estate assets. Depending on the group of investors, you can be as passive or active as you want. In some cases, you have shares in the property. In other cases, you can take a more firsthand approach.

Budgeting—Putting It All Together

The more you understand the costs associated with investing in residential real estate, the easier it is to maximize profits. Your budget must include money for the down payment, closing costs, and a contingency fund. Additionally, budgeting for steady cash flow is crucial. This means having enough income to pay for operating expenses, regular maintenance, and vacancies.

Knowing how much money you need to invest in real estate can help you make the best investment decisions. You ensure your rental property, house flip, or rehab helps increase wealth and builds a successful real estate investment portfolio.

This post originally appeared on the BiggerPockets blog.