Becoming a landlord check out the costs first

April 22, 2013, 7:31 a.m. EDT

Before becoming a landlord, add up the costs

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By Anya Martin, MarketWatch

One of life’s luxuries is being able to afford a vacation home. But don’t underestimate its true cost—especially if you plan to rent it out.

Doug Lebda, chief executive of Lending Tree, made a bigger down payment and pays higher interest rates because he plans to rent out the $960,000 beach condo he bought with his dad in Wilmington, N.C.
To get the three-bedroom unit, Lebda put down 25% of the purchase price and received an interest rate of 3.86% for a seven-year fixed/20-year adjustable-rate mortgage. He estimates that their interest rate is one-quarter percentage point higher because it is a second property, and an additional one-eighth percentage point higher because of their plan to rent.

Logan Mock-Bunting for The Wall Street Journal

Lending Tree CEO Doug Lebda and his father, Bob.

“Everything across the board was tighter,” Lebda said. “Thankfully I was well within the guidelines for debt-to-income ratio and credit score.” The beach condo is a joint investment with his father, Bob, who has bought and managed rental properties for years. They expect to collect as much as $3,500 per week during peak summer season from vacationers, but before Lebda took out the mortgage from a bank in the Lending Tree network, he also calculated anticipated costs, including maintenance, marketing and insurance premiums.
“If you are smart about what you buy and you are really detailed about the costs, there are certainly opportunities out there which will be cash-flow positive,” Lebda said.
The lure of rental income is a big driver for vacation-home purchases, said Jon Gray, senior vice president of HomeAway, a company that provides online listings for vacation-home rentals.
In a survey by the National Association of Realtors, 92% of 2012 vacation-home buyers said they planned to rent their property within 12 months, and 76% said the potential for rental income influenced their decision to make the purchase.
Beyond a second income source, many older buyers who are approaching retirement age are taking the opportunity to purchase a high-end second home at a more affordable price now and rent it out until their retirement, Gray said.
Driven by still-low prices and low interest rates, vacation- and investment-home sales were strong in 2012, with vacation-home sales accounting for 11% of all residential transactions, NAR reported, up from 9% in 2008. Vacation-home sales increased by 10.1% last year, but investment purchases, as expected, declined slightly by 2.1% due to decreased foreclosure inventory, said Walter Molony, an NAR spokesman.
The volume of loans for second homes rose about 15% last year at Shore Mortgage, and that increase carried into the luxury vacation-property market, said David Hall, president of the Troy, Mich.-based national lender. A Shore jumbo borrower who plans to rent can expect to make a 30% down payment and an interest rate about one-eighth to one-quarter percentage point higher than for a standard second home. Median 2011 down payments were 27% for vacation homes at all price points, according to NAR.
Shore Mortgage also asks buyers to show proof of cash reserves totaling at least six months of loan payments and a credit score of at least 720. With second homes—especially rental properties—a lower credit score won’t always kill a deal, but a higher credit score may mean some relaxation on the amount needed in reserves, Hall said.
Borrowers need to disclose to their lender that the property will be rented, because underwriting rules are different, said Kris Yamamoto, a Bank of America (NYSE:BAC) spokeswoman.
Lenders also require appropriate insurance coverage for a vacation home that will be rented, and policies tend to be pricier than for primary properties. One reason is that a beach or lake house may require flood coverage, said Jeanne Salvatore, consumer spokeswoman for the Insurance Information Institute. “All the reasons…that make a vacation property more desirable will also make it more expensive from an insurance perspective,” she added.
Liability coverage may need to be higher when renting to others, and some insurers offer special products for luxury properties, Salvatore said.
Here are a few more considerations before you borrow:

• No counting your chickens: A borrower cannot estimate a property’s rental income to show proof of being able to maintain mortgage payments, according to Bank of America.
• Check local rules: Before buying in a resort community, borrowers should check homeowner-association rules to ensure short-term rentals aren’t prohibited. Also factor in association fees when estimating costs and setting rents.
• Calculate all costs: Anticipate expenses, such as hotel-occupancy taxes, advertising, maintenance, maid service and management-company fees.