One of the best sources of passive income aside from stocks and bonds is buying an investment property.
Investing in a residential condominium, an apartment or an office unit for purposes of renting it out generates steady monthly rental paychecks similar to buying a dividend-paying stock or bonds that pay interest income.
Any appreciation in the market value of real estate comes only as an extra benefit from holding the investment over time. The higher the rental income the property generates, the higher the prospective value appreciation in the future.
But as in any investment, there are always risks that the rental property may not generate the returns that you expected. Rental rates may turn out to be weak because the supply of condo units in the area may have exceeded potential demand, or the price that you paid to acquire the property may be too much.
Unlike in stocks or bonds when you can immediately liquidate your investments when you need it, it is not easy to sell a real estate property. It takes weeks or months before you can finalize a sale, and sometimes when your property is not in a favorable location, you may have to unload it at a loss.
While it is nice to think that buying a rental property provides an alternative income stream, it takes effort on your part to spend some time studying the area. Remember that you are buying a property that you will own for the next five to 25 years.
These properties will become part of your life for a very long time so try to take time to research and learn. There is no need to hurry to make a decision to buy because your property agent says so.
If you buy properly, there will never be a problem when you want to sell it later, but if you buy the wrong one, it would be hard for you to pass your mistake to someone else in the future.
Here are the five tips every investor needs to know before buying real estate for passive income:
1. Know your target market
The most important factor in selecting an investment property is the location where you can identify your potential market. Every location has a different market.
For example, if you are investing in a condo unit in the Ortigas business district, your target market may be expats or call center agents, but if you are investing in the residential area of Quezon City, your target market may be a family with children or young couples.
The location of your property matters a lot since this will affect the sustainability of your rental income, as well as your ability to negotiate for a higher monthly rent. A good location is one that offers convenient access to basic needs of your tenants such as a supermarket, good restaurants, public transportation, hospitals and schools.
2. Know your investment budget
Once you have identified the location and your target market, your next step is to determine how much money you are willing to invest. The bigger the amount you spend, the higher the return on investment you should expect.
Your budget extends beyond the cost of the condo unit. You also need to budget for the possible renovation of the unit, as well as the costs of the furniture that you will put inside. If you are looking to get a decent return on investment from your property, you need to manage your budget against your expected rental income.
Although you can use the prevailing market rate in the area as a guide for expecting your rental income, there is no guarantee that you can get it because tenants normally negotiate and compare your unit with your other competitors in the building.
It is always advantageous if you can manage to lower your investment budget. The lower your investment cash outlay, the higher the chances that you will get a good return on investment.
3. Know your return on investment
If you put your money now in the money market, how much are you going to make per year? If you are going to take out your savings from the bank and invest in a condo rental property, you should make at least higher than what you are currently earning from the bank.
If the interest rate is rising to six percent, you can target a return on investment of at least eight percent or higher depending on the premium you want. If you are buying a brand new condominium, the first thing you need to determine is your expected return on investment.
How much return on investment would the property generate based on the selling price and market rental rate in the area? Will the return maximize your investment considering all the risks?
The key to achieving high return is when you have low investment outlays. If buying a brand new condo fails to meet your criteria, you may also consider buying a secondhand condo unit in a very good location, where you have room to negotiate for lower costs.
4. Know your options to leverage
There is nothing wrong with investing using your cash, but if you can borrow to buy a condo rental property, you can maximize your cash investment. With financial leverage, you can possibly buy two or three condo properties for the budget of one unit.
For example, if your budget is Php2 million to buy a single condo unit that you plan to rent out, you can actually buy two condo units by paying Php1 million for each as 50 percent down payment and borrow the balance from the bank. Or you can buy three condo units by paying one-third of the price as down payment and borrowing the rest from the bank.
When you borrow to finance a condo unit, the bank actually helps you do extra due diligence to make sure that the title of the property you are acquiring is clean. This is especially helpful when you are buying a secondhand property, where you need to validate the history of ownership.
5. Know the terms of your loan
When you decide to finance your investment by borrowing, you can shop for the right bank that can give you the best deal. The ideal loan deal that you want to get is the one that can give you the lowest monthly amortization possible.
You want your monthly rental to be at least equal to your monthly amortization so you don’t have to cash out anything, but it would be better if your monthly rental is higher than your amortization so that the extra cash will be your income.
Your monthly amortization is a function of the term of the loan and the interest rate. The longer the number of years that you need to pay the loan and the lower the interest rate, the lower the amortization will be.
Normally, banks will give a maximum of 15 years for a condo unit and an interest rate that can be subject to annual re-pricing or fixed for a number of years. You will need the bank to compute for you the monthly amortization based on the terms offered and you can evaluate if it is financially feasible to you or not.
Henry Ong, RFP, is president of Business Sense Financial Advisors. Email Henry for business advice firstname.lastname@example.org or follow him on Twitter @henryong888