How to Buy an Investment Property
Read on to find out if investing in rental properties is right for you.
It sounds so easy. You buy a home, put out a “for rent” sign in the yard, a nice family moves in, and you start collecting monthly checks. If only investing in real estate was that simple! The good news is it's not rocket science either, and you can be very successful in investing in rental properties with an understanding of the basics and a fair amount of due diligence. But first, you need to know how to buy an investment property and determine if it's right for you.
How to Invest in a Rental Property
In comparison to other investment options, rental property investing requires you to be actively involved in the process. You should, though, think about whether or not you have the time and desire to participate before you jump in.
If you've decided to buy an investment property outright, as opposed to passively invest via crowdfunding and real estate investment trusts (REITs), here are steps you need to take.
1. Secure Your Financing
Unless you have a lot of cash sitting around, you need to line up financing for your rental property acquisition.
Before you start identifying properties you want to buy, you need to get pre-approved for a mortgage loan. Similar to getting a mortgage on a primary residence, a bank or lender will look at your current income, credit score, and other factors that indicate you are a reasonable risk.
The best loan terms and interest rates go to the lowest-risk borrowers. That means you must maintain a good credit score and keep your debt-to-income ratio below the bank's requirements. You can use personal finance platforms to monitor your credit score and your overall finance.
You also need to put down more money on an investment property loan than when buying your own home. Non-owner-occupied homes require a larger down payment because they are a more significant lending risk. Banks typically require at least 20% down. Lenders usually will not consider anticipated rental income to qualify you for a loan.
You will also need to set aside ample cash. You will need at least three months' worth of anticipated rental income for things like maintenance, possible vacancies, and ownership expenses. It's a good idea (and will help your chances of qualifying for a loan) to pay down personal debt before taking on the responsibilities of owning and renting properties. If you need some extra cash you can consider a service like Hometap, which invests in the equity of your home. You get the cash you need and Hometap gets some of the proceeds when you decide to sell your home, or if you decide to settle the investment before the 10-year term is up.
Or if you rather get a loan to use for repairs and other unexpected expenses, you can use Monevo to compare loans and find one that's right for you.
While most investors use a mortgage to finance rental property purchases, there are other options to consider. You might even consider buying rentals with the money in your IRA.
2. Choose What You Want to Buy and Where
One of the most important decisions is where to invest. Across the United States, there are some great rental markets and some not-so-good locations where it's impossible to purchase a rental property that will provide positive cash flow. Research home and rental prices (as well as other local details) to find the best places to invest in real estate.
Real estate markets are extremely local, and it's advantageous to work with an investor-friendly local real estate agent who has access to real-time and historical data to help you find and acquire good rental properties. You can find one using a free service like HomeLight, which will match you with the top three agents in your area.
When choosing a location, you should consider the pros and cons of rental property types. You might choose a townhome, condo, single-family home, or duplex. If you're not the handy type, a condo (where the roof and exterior are not your responsibility to maintain) might be a good starting place. A townhome or duplex requires more maintenance than a condo but not as much as a single-family home.
In addition to types of rental property, there are different classes of rentals:
- An “A” property is a luxury home in a great neighborhood that would attract highly qualified, reliable renters. It also may cost too much for good cash flow.
- A “B” property is on the higher end but still affordable for a small family.
- A “C” property may not have high-end finishes or be in the best neighborhood but will be extremely affordable for tenants.
- A “D” property would be in a much less desirable location but would also cost much less to purchase, and therefore cash flow would be on the higher end.
3. Choose Your Strategy
Rental property investing is a strategy that involves buying properties that are rented, giving you monthly income. For a property to have positive cash flow, the rental income must exceed all the costs of owning and maintaining it. There are a number of ways that you can go about investing in a rental property.
Get Started Without Getting Your Hands Dirty
If you're intrigued by the idea of investing in rental properties — but don't want to hassle with fixing toilets in the middle of the night — check out Roofstock. This is an investing platform that lets you purchase pre-vetted turnkey properties. There's no need to do any of the heavy liftings. Properties are taken care of by certified property managers (or you can choose to DIY if you prefer). There's just a 0.50% fee, so if you purchase a $100,000, you'll have to pay just $500. That's a good bit cheaper than what you'll be charged by a real estate agent.
- Own Real Property
- Non-accredited Investors
- Cash-Flow Positive Investments
Invest in Crowdfunding
Crowdfunding is a strategy that's more passive than owning actual property, making it a great strategy for beginners.
- Real estate crowdfunding means pooling your money with a group of investors to make a more significant investment in a property or group of rental properties. That means the minimum investment is easier on the wallet. Some crowdfunding platforms offer investments as low as $500.
- On many crowdfunding platforms, you'll find properties that are already vetted and have cash flow. This is ideal for investors who don't want to deal with the hassles of researching, buying, repairing, and leasing properties themselves.
- Crowdfunding is more comfortable and more affordable than buying a property outright. But many crowdfunding sites limit access to deals to accredited investors only. Also, easier doesn't mean less risky. You still need to do extensive due diligence on the crowdfunding company and the specific investments before diving in.
“House Hack” Your First Rental Property
As a beginner, a great way to start investing is to “house hack.” This is a slang term for buying a rental property that you'll live in at the same time you rent out part of it.
Often this takes the form of buying a duplex. You live in one side and rent out the other side to tenants. Or if you're single, buy a three- or four-bedroom single-family home and live in one room and rent out the extra bedrooms to friends or peers.
Ideally, house hacking allows you to live rent-free because the rental income from your roommates (or tenants) is sufficient to cover all property costs.
One benefit of house hacking is that you're onsite to manage the property, so you don't have to pay for property management when the tenant clogs the toilet. Of course, a downside is that you might not like living in the same duplex as your tenants or sharing the kitchen of your home with roommates in a single-family residence.
Invest in a Turnkey Rental Property
Another option that offers a higher level of passivity than purchasing and managing rentals yourself is buying a turnkey property. There are companies in the business of acquiring properties, turning them into ready-for-market rentals, and then selling them to investors.
In most cases, you're buying a new or fully renovated property that's already tenanted, and the turnkey company manages everything for you. That means you won't have to worry about finding and screening tenants, maintenance issues, or overall management. You'll want to do your due diligence and understand what you're investing in and the unique risks.
Buy a Single-Family Home
Another way to invest in rental real estate is to buy a single-family home and rent it out. The market for single-family homes isn't propelled solely by live-in buyers. In fact, even hedge funds have stepped up their intangible interest property, purchasing homes to rent as perennially falling rates allow for higher returns on invested capital.
So what's so hot about single-family homes? Low costs of borrowing and excellent spreads between rental prices and mortgage payments. Elsewhere, investors are padding the real estate market with fresh cash to make their foray into the rental business. Read more about single-family homes and why they could be a good investment.
4. Research and Analyze
Make sure you do proper due diligence on all aspects of every deal. There are a lot of so-called “deals” touted, but you need to make sure you get it right. How much will the rehab cost? What are the monthly holding costs? What permits do you need and how long will it take to get them? The list of questions you need to be answered is extensive.
A property is a huge investment, not a consumer product that can be returned if you don't like something about it. That foundation crack will need to be fixed and will be expensive. The mold in the back of the closet might need professional mold remediation, which is also expensive. It's way too easy to go into the red on a property. Checking it out personally before I buy is simply a must-do every time.
Obviously, make sure your numbers are right when evaluating deals. I frequently see investors focus on the listing price of active comps (similar properties currently on the market for sale) when estimating a property's after-repair value. The listing price of a property is really just a guestimate arrived at by an owner or real estate agent. The real market price of a house is the final price agreed to by the buyer and seller. Recently sold properties are more indicative of a similar property's market value than active or even pending listings.
It takes knowledge, experience, and persistence to research and analyze deals. And you'll always regret it if you don't do so thoroughly!
5. Always Get an Inspection
Never (and I do mean never!) buy a home unseen. Even if I know the neighborhood and can view hundreds of photos online; Even if the price is so low that I know it'll be scooped up quickly if I don't act immediately, I don't make an offer on any property unless I've walked inside it personally. A seller isn't going to post the picture of the standing water in the basement corner.
Hiring a professional licensed inspector is a not-to-be-missed step.
- He will inspect the condition of the foundation, roof, plumbing, electrical, HVAC, appliances, etc.
- Then he'll give you a report of what needs immediate repair and what will need fixing in the near future.
For example, the water heater may work fine now, but the report reveals that it's past its intended useful life. You'll want to know this so you can decide if you're going to replace it before you put tenants in the property or budget for an immediate replacement when it stops working.
I broke this rule myself and got burned. I decided not to get an inspection on a home that was well maintained and looked in great shape. Both the seller and I wanted to move forward quickly. I had my team ready to start the renovation. Everything looked good to my contractor and me during the final walkthrough. I took the word of the owner that all systems and appliances worked. She was living in the house and seemed trustworthy. But it turned out the plumbing in the second bathroom had to be completely redone. (Perhaps the seller didn't know about the issues because she lived alone and had been using only one bathroom for years.) An inspection would have revealed the problem. I could have avoided a repair cost that put me over budget and diverted precious rehab resources from their intended use.
Investor Tip: If you're planning on renting the property, get your inspector to do a rental inspection simultaneously, which will save you time and money.
6. Make Sure You're Insured
A homeowner insurance for rental properties is sometimes called “landlord insurance” and is also known as a “dwelling fire policy” or “fire and special perils policy.” Homeowner insurance covers your house if it burns down or there's a break-in. And it pays medical and legal bills if someone gets hurt on your property. When you rent out a home, there's a higher risk of loss to you and your insurer.
This insurance covers the house itself, other structures on the property (such as a garage or shed), the owner's (not the tenant's) possessions, lost rental income if the house is damaged and uninhabitable, and some liability protection for the owner in case of an injury or lawsuit. Read the fine print and all the exclusions.
Landlord insurance is a more expensive must-have that helps protect you, your property, and your tenant. If you have a mortgage, your lender will demand you carry it.
7. Submit Your Best Offer
Make an informed offer in writing using state-approved contracts, and back it up with proof of funds that you're able and willing to close if your offer is accepted quickly. Along with your offer, you'll typically need a copy of the bank statement from which your down payment will come, a pre-approval letter from your lender if you're financing the purchase and an earnest money deposit check.
There are a lot of negotiation strategies, and it seems everyone has an opinion about what works best. However, after several deals, I realized that haggling is counterproductive most of the time (and gets extremely tiresome very quickly). I make my best offer initially and walk away if it's not accepted. I don't enjoy sparring — investing isn't a sport. There's a price at which my numbers make sense. If I can't acquire the asset for that price, I move on and look for a deal I can get done where the numbers do make sense.
8. Weigh the Risks and Rewards
Owning rental properties is a long-term investment. Transaction costs are high, and real property is an illiquid asset that you can't sell quickly if you need cash. So, make sure you do your due diligence and weigh the risks and rewards of rental property investing.
- Huge tax benefits including taking depreciation on an asset that is likely appreciating
- Collect monthly rental income
- Provides portfolio diversification (real estate is not correlated to stock market fluctuations)
- High potential for asset appreciation
- Tenants pay off your mortgage, providing you with equity at no cost to you
- Potential for negative cash flow due to bad tenants or a high vacancy rate
- You take on landlord responsibilities
- Your property value is subject to housing market fluctuations
- You could lose money by underestimating expenses or overestimating rent
- You can't sell quickly if you need emergency cash
9. Accurately Calculate the Expenses of Owning a Rental Property
The main operating expenses — which are easy to calculate and budget for monthly — are:
- landlord insurance
- property taxes
- homeowners association (HOA) or condo fees
- property maintenance
- mortgage payments.
Be sure to factor in unexpected costs as well. You'll have regular maintenance costs, such as replacing HVAC filters. And you'll likely have repair costs that will vary year to year based on when appliances break or wear out and need replacement.
The initial purchase of the property has unique expenses, including closing costs (such as transfer and recordation fees), lender and title company fees, and escrow items such as property taxes and mortgage insurance. Budget for future expenditures such as a new roof, water heater, and appliances.
10. Learn to Calculate Cash Flow and ROI
How will you know if you'll make money on your rental? There are many factors, but a quick calculation of your Return on Investment (ROI) and Cash Flow will help you evaluate whether a property will make an excellent rental investment.
- ROI is calculated by dividing the annual income by your total investment. If your rental income is $15,000, and you paid $150,000 for the property, your ROI is 10%.
- Cash Flow refers to how much money you make from your investment each month. If you collect the rent of $1,500 and your expenses total $1,200, your property cash flow is $300 per month.
11. Know Your Legal Obligations
A lease is a legal contract that binds both the landlord and the tenant. State and local laws differ, but in general, landlord-tenant law addresses five aspects of the relationship:
- How much security deposit a landlord can charge and how it is held
- What information the landlord must communicate to the tenant, such as disclosing the possibility of lead paint
- Rules of possession of the unit
- Maintenance responsibilities
- Landlord liability
As a landlord, you enter into a legal contract to allow tenants to possession of your property. You must provide “safe and habitable” living conditions. This means you must address property maintenance issues on time. And you must respect your tenant's right of possession – you cannot enter the property without providing proper notice.
What Makes a Good Investment Property?
A rule of thumb most investors use when evaluating a property's rental viability is the “1% rent multiplier rule.” The monthly rental income must be equal to or greater than 1% of your initial investment. So, if your total cost to get the property rent-ready (purchase price, closing costs, renovations) is $150,000, the property should rent for at least $1,500 per month, net of HOA or condo fees.
Of course, real estate markets vary widely across the country. In some metro areas, it's common to be able to get a rent multiplier well over 1%. But there are many locations where it's challenging to get anything close to 1%. In such areas, what makes other factors may determine a good investment property.