How To Make Money With Rental Properties | Cottage
Interested in generating real estate passive income? Learn more about how to make money on rental properties and ADUs here.
Updated Jan 01, 2018
As the housing market continues to experience a shortage in stock and ever-increasing demand, property ownership can be a lucrative investment opportunity for would-be landlords. Real estate investing is a popular way to build or diversify an investment portfolio and access critical passive income streams.
Whether it’s commercial properties, single-family homes, or multi-family units, real estate investors need to do their due diligence upfront to ensure an attractive bottom line at the end of their dealings.
Outside of the standard contract purchase price, closing costs, and renovations, many other factors can affect your residential rental property.
California is currently going through a severe housing crisis, which means that buying an entirely new property could be prohibitively expensive. But building an accessory dwelling unit (ADU) is a practical, flexible, low-cost way to acquire an income without purchasing a separate property.
ADUs are secondary housing units located on a single-family residential lot. You can use them for office space, family housing, or even for generating passive income by renting them out. With California’s newest legislation streamlining the construction of these accessory dwelling units, there’s never been a better time to act.
Buy Below Market Value To Build Wealth
If you decide to buy a new property, you must do your homework to ensure capital gains. The basic rule of thumb is that your total property acquisition costs should total no more than 80% of the property’s value once restored. That’s the key to passive real estate investments.
This figure may feel arbitrary, but sticking to it will give you instant equity. It also provides the possibility of generating rental income from day one.
Research the area where you’re looking to buy. Focus on recently sold properties with similar square footage, bedrooms, and bathrooms. You’re hunting for a bargain, so don’t be discouraged when the task proves difficult.
Where and How To Look for Rental Properties
Let’s take a sample from an area in California where the median market property value is about $687,500. Figures will naturally change in your investigation, but for the sake of this example, we will use this number that breaks down relatively evenly.
With the sample property’s value in that area standing at $687,500, you will need to find a house on the market with a contract purchase price of $500,000. When looking for a property at this low a rate, you’re most likely not going to find a move-in-ready house.
Because properties this low in price may be hard to find, a great option to consider is an ADU. The cost of building an ADU is often much lower than purchasing a single-family home.
A bevy of real-estate websites and apps may help your search. Many of these applications have features where you can filter by price range and square footage, as well as functions that add your favorite homes to a watchlist for possible price drops.
Why 80 Percent?
80% may seem arbitrary; why not another number like 70% or 85%? In reality, these other percentages may even work better depending on your deal. 80% is not a hard and fast rule, but this investment strategy is still a helpful guideline.
One benefit it provides is instant equity in the home. This equity ensures that the property will generate a consistent monthly income. That, or at least break even to avoid incurring a loss.
It also provides a safety net in that a bank would typically use this 80 percent figure as the value it refinances your home at. In the worst-case scenario, your money can be safely taken out of the deal.
Depending on your rent, this figure can also help create a positive cash flow.
As stated, this isn’t a golden rule by any means and can be adjusted depending on context and circumstance. Consider certain aspects such as property taxes, home insurance, and utilities like water and gas.
Other costs to consider include upkeep, maintenance, and management (if you’re not near the property). All of these fees can build up to half of your gross rent.
Whatever margin you decide works best for your situation, make a point not to let your total acquisition price go over 90% of the home’s market rate. These margins would be far too slim to develop a positive cash flow; you risk being over-leveraged. This is a dangerous threshold to cross, as it can affect your future investment opportunities.
What Factors Influence Rent Prices?
Congratulations, you’ve acquired the property for about 80% of its market value. Maybe you lucked out and found a steal on the market, or you went the more pragmatic route and built an ADU.
To reiterate, building an ADU for $200-$300k is more than 80% of the market value that the ADU brings to the home. This makes an ADU an intelligent investment and genuinely makes it the pragmatic option for acquiring a rental property. With ADUs, you don’t have to struggle and rely on luck to find a miracle — you can build a rental unit on your own property.
Still, now that you have you’re rental property, you need to find a tenant to generate a positive net income on your rental real estate investment.
What you charge in rent will highly depend on what state and city you live in. It can also depend on local factors such as desirable school districts, a thriving arts and culture scene, golf courses, or stunning views.
For example, in Northern California, Google is eyeing downtown San Jose as the prime location for their new campus. This would bring 20,000 tech and 8,000 service employees to this already-popular area. Projected figures from think tank Working Partnerships USA estimate rent rising at $765 per apartment.
In such situations, ADUs pose an ideal solution to corporate-owned apartments and mega-complexes in terms of affordable, high-standard housing.
How Much Should You Charge for Rent?
The general rule of thumb is that the rent charged must be proportionate to the total property acquisition cost, not the market value. Consider factors based on your state (for instance, California has laws about how much landlords can raise rent yearly).
Idealistically, homeowners will charge 1% of their home’s value for long-term rentals. When that percentage isn’t possible, the range usually lands between 0.5% to 0.8%.
Building an ADU is often easier and faster than a traditional home. As such, an ADU can collect rent faster. Additionally, as ADUs are often smaller, more efficient spaces, if the homeowner covers utilities like water, electricity, or gas, these numbers won’t affect the bottom line as much as a larger home would.
To Finance, or Not To Finance?
You have a few different options depending on your current financial standing and investing goals. Paying all cash upfront removes the need for a mortgage and can be an attractive point for sellers, but not everyone has access to this avenue. In that case, buyers might need to consider other options, including the various types of mortgage options or owner financing.
The first option is traditional mortgages. Some of these mortgages are backed by government-sponsored enterprises (GSEs), which are third-party mortgages regulated by the Federal Housing Finance Agency (FHFA). These include Fannie Mae and Freddie Mac, which have specific requirements in terms of credit scores, debt-to-income ratios, and more; however, you also have the option to purchase mortgages not backed by Fannie Mae or Freddie Mac.
Another financing path could be owner financing. Owner financing tends to result in quicker closing times, fewer closing costs, and flexible down payments. Additionally, this option appeals to those who may struggle to qualify for a traditional mortgage.
However, with owner financing, if the buyer defaults on the home, the original owner keeps any money paid and the title. The buyer will likely see higher interest rates and a potential balloon payment after a set amount of time (often five or ten years).
Finding a Mortgage for a Rental Property
If you’re looking into financing a property purchase, the most common path is a mortgage. There are several things you need to account for when trying to ascertain a mortgage on your rental property:
Credit Score: The best terms and agreements can be offered to those with a score of 720 or higher. You will need a minimum score of at least 620.
Down Payment: Placing a down payment of less than 20% is possible with many lenders. Others may require the more costly Private Mortgage Insurance (or PMI).
Debt-to-Income Ratio: DTI is the relationship between a borrower's monthly income and how much that goes to paying off existing debts.
In today’s housing climate, property purchasing power in many California communities has been funneled to real estate moguls and development firms. It can be novel to think of transforming from a typical homeowner to a developer or investor, and it’s entirely possible!
Get excited! New legislation passed by the State of California has opened the development floodgates for ADUs. There is now a streamlined system to develop additional housing on your existing property with an attached, detached, or conversion ADU.
Renting Possibility With ADUs
ADUs provide far more financial freedom than buying new lots or homes—financial independence and creative freedom. ADU plans, like those from Cottage, can be as unique as the homeowner or the intended renter.
Accessory Dwelling Units, or ADUs, have a wide range of uses beyond rentals. Some people use these spaces to house elderly loved ones or older children, while others use them as a home office.
ADUs can also serve as a reliable income source, as these units can be rented out to tenants.
Financial Impact of ADUs
Thanks to legislative reform in recent years, there has been a growing wave around ADUs. These homes not only add a great deal of value to your existing property but allow you to save money while generating a steady cash flow. ADUs are a fantastic place to start your rental property journey.
Making Investments Easy
ADUs offer more than a gateway to rental property management at a lost cost. A fantastic benefit of having an accessory dwelling unit is that it is an “accessory” to your primary residence. Your tenants are just a few steps away, so you can keep close watch over your ADU asset, and responding to tenant requests or issues is much easier than from a distance.
Cottage offers dozens of ready-designed floor plans to choose from. These are presented to you as modular designs that can be mixed, matched, and rearranged to fit your vision.
ADUs are a fantastic addition to any property and an excellent investment. They add property value, unlock opportunities for rental income, and offer space with serious utility. If you’re looking to make money with rental properties, Cottage can show you how an ADU is the right path if you want to make money with rental properties.