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Thinking of buying a rental property as an investment? There are plenty of potential benefits, such as:
- Earning passive income as a supplement to other business revenue
- Making a stable investment that has historically grown in value
- Establishing a business that can scale up over time, from a single property worth six figures to a portfolio with a potential combined value of many millions of dollars
- Ownership of a tangible investment that has a physical presence and basic minimum value that won’t drop to zero
But you have to be smart about it. A rental property may earn passive income for you, but you have to make active, educated decisions about financing, management and maintenance.
Investing in a rental isn’t the same as occasionally renting out your second home to vacationers. This is a business, and you need to answer a few questions before investing in it.
- Can you repair things around the house yourself?
- Are you comfortable serving a tenant with an eviction order?
- Do you know what the tax bill will be?
Still interested? Read on to learn more about how to buy a rental property in five steps.
1. Know What To Consider When Buying Rental Property
Buying rental property is a major investment. Deciding to invest is likely going to cost you money upfront – lots of it. Here are some things to consider before you take your first step into buying a rental property.
Location, location, location
Everybody always talks about location – and there’s a good reason why. Location is possibly the biggest single factor that will determine how much demand there will be for your rental.
Before you invest, research rental rates for similar properties in the area that you’re considering. No two properties are alike, but this will give you a decent ballpark range. Check out crime statistics and local amenities, like schools and parks, and proximity to shops and clinics or hospitals.
Upfront and ongoing costs
There are costs to consider when buying an investment property. For instance, a lender may require a larger down payment on a rental property than they would for a residential mortgage. You might also have a higher interest rate, extra insurance and a bigger property tax bill with an investment property.
Property management: DIY or management company
We’ll discuss this in more detail later, but property management is another important factor to consider from a convenience and cost perspective.
While you might decide to manage a house or a duplex, managing multiple rental properties may be too much for you – especially if you don’t have the time, experience, or skill to tackle issues when they arise.
Before signing up with a property management company, be aware that the costs can be high and will eat into your revenue. It’s important to weigh the benefits and costs before deciding.
Because of the economic downturn caused by the COVID-19 pandemic, the federal government issued a nationwide moratorium on evictions for nonpayment of rent.
While the ban on evictions provided relief for millions of renters and state and federal funds were set up to help compensate landlords, many property owners faced difficult financial challenges.
Even when you’re not dealing with a pandemic, as a landlord, you may need to deal with periods when tenants are late with rent or unable to pay it at all. Even with an eviction as an option, you’ll need to be ready to cope with periods when you’re unable to collect rent until you can find new tenants.
2. Look Out for Red Flags When Buying Rental Property
Any investment carries a certain amount of risk, and rental property is no exception. Be on the lookout for anything that raises a red flag or suggests an issue with the property.
There are three basic categories of red flags: problems with the property, problems with the seller and problems with the deal.
Problems with the property
Unless you’re buying a fixer-upper, nothing wipes out a rental property’s investment value quite like discovering cracks in the foundation or leaks in the roof.
It’s always a good idea to get a roof-to-foundation property inspection completed. Issues to look out for during an inspection include:
- Active leaks or signs of water damage
- Obvious structural damage (like cracks or crumbling masonry)
- Mold in bathrooms or kitchens
- Misaligned window frames or other signs of poor design or construction
- Signs of wood-boring beetles or termites
Problems with the seller
Getting into a purchase agreement with a problematic seller could sink your deal and, depending on the circumstances, may expose you to civil or criminal liability. Here are some warning signs that your seller may not be the right partner:
- Long and/or unexplained delays in delivering information, such as a roof inspection or electrical system upkeep documents
- Difficulty reaching the seller or getting emails and calls returned
- A history of Better Business Bureau® complaints, criminal investigations or bad word-of-mouth from past buyers
- Unusual or illegal requests, such as misreporting the sale price or other tax-evasion tactics
If you suspect the party you’re negotiating with is unreliable or engages in unethical business practices, walk away from the deal as soon as your suspicions are raised. You may also want to consult a lawyer to make sure you don’t have any legal exposure or contact the authorities to report suspicious activity.
Problems with the deal
Even if everything about the property and the seller checks out, you could still have a bad deal on your hands. It could be anything from not being able to get an affordable interest rate to factoring in an unexpected expense that makes the potential ROI less attractive.
Some of these factors are going to be under your control – others aren’t. Factors that won’t be under your control might include:
- Requests for more information from your lender, requests that you carry additional insurance or unusually long delays with loan approval (which could signal issues with your application)
- Economic slowdowns or a job loss that affects your ability to demonstrate income
- Local hikes in property tax rates, statewide rent control, zoning changes or other government actions that cut into your bottom line
- Environmental concerns or issues that basic homeowners insurance typically doesn’t cover, such as floods, earthquakes, pandemics or civil disturbances
3. Plan Your Rental Property Investment
Whether your rental property is large or small, it will be a significant financial investment. It pays to plan out your purchase and try to anticipate your expenses. Remember, there are significant differences between investing in a rental property and buying a family residence.
Getting a mortgage
Lenders generally consider loans for rental properties to be somewhat riskier than residential home loans. When faced with bankruptcy, property management companies are somewhat more likely to cut their losses than families living in their homes.
That means the loan you get to buy rental property will probably come with a higher interest rate than the typical home loan.
You should also expect the lender to require a higher minimum credit score than they would with a private home loan. You can typically get a residential mortgage by putting as little as 3% down. Commercial mortgages almost always require a down payment of at least 15% – 25%.
Getting the loan isn’t the end of the story. You have to plan for the expenses of rental property ownership. Owning a piece of rental property is a business. And it comes with a few expenses that are unique to rental properties. Consider these expenses the overhead costs you’re going to be dealing with.
The expenses and costs you should plan for include:
- Property and income taxes
- Utilities that aren’t a tenant’s responsibility (water, sewer, trash collection)
- Landlord insurance (which is a legal requirement in many areas and will likely be required by your lender)
- Maintenance and cleaning fees
- Emergency repairs (fixing a broken water pipe or repairing damage caused by a tenant)
What makes a property a good investment?
Not every property is a good investment opportunity. Some are diamonds in the rough you’ll only be able to spot if you know what to look for. Before you commit to a purchase, make sure you know the property value and likely potential for growth and get a realistic idea of any risks.
The concept you’re working on here is your return on investment (ROI), which is a good measure of whether a property is a good buy. As a rule, you should aim for a minimum of 8% annual ROI as a combination of bottom-line revenue and an increase in the property’s value.
An 8% annual ROI is the bare minimum. In most areas, a target of 12% or higher is more realistic.
But these are general figures. Your returns are bound to vary based on location and the type of property you invested in.
Depending on how you set things up, your ongoing expenses can also vary from one property to another.
4. Know How To Pay for Rental Property
Paying for your property is one of the biggest challenges you’ll face as a real estate investor. Doing this right makes a world of difference in how profitable the investment turns out to be. Remember, there’s a difference between the type of loan you can take out to buy a rental property and a mortgage for a primary residence.
How do I finance a rental property?
Loans for rental properties are riskier than home mortgages. Here are the major differences between a mortgage on a house and a loan you get to buy rental property:
- Down payment: With a primary residence mortgage, the standard down payment is 20%. If you’re willing to pay for mortgage insurance, most lenders will let you make a smaller down payment, sometimes as low as 3%. With a rental property, expect your lender to insist on a 15% – 25% down payment.
- Interest: You’ll probably pay higher interest rates on a rental property loan. Instead of judging risk based on income, a lender for rental property looks at the profitability of your future business. The standard expectation is that your revenue will be 125% of the monthly loan payment, but this can vary. To cover their risk, lenders typically charge a higher interest rate.
Repayment terms: With your home mortgage, you can likely choose a repayment term that ranges from 10 – 40 years. Loans for rental properties are much less flexible. The industry standard is a 15-year repayment term.
5. Dominate Your Rental Property Management
Once you close on the deal, responsibility for maintaining the property falls on you. Whether you have tenants or not, you’ll have to pay property taxes and insurance.
Plus, every building needs maintenance. If something breaks, the local creek overflows onto your property or the county sends you a letter about code compliance, you must take care of it.
After location and property type, how you manage your rental property may be the most important factor that affects your bottom line. The most common approaches are to manage the property yourself, partner with a property management company or find a real estate partner.
Do it yourself
If you feel confident that you know what you’re doing, try your hand at managing the property alone. This means you take care of site prep and any needed repairs, find tenants, act as the tenants’ point of contact for rent and handle anything else that comes up, like inspections and evictions.
This can be a lot of work, but it saves you money because you don’t split your revenue with a property manager.
On the other hand, if you run into problems like a lawsuit, IRS audit or a major repair that you’re not qualified to make yourself, property managers may be better equipped to handle these problems as a part of their service package.
Even if you need to pay extra for specialized services, property managers may have existing relationships with lawyers or technicians and may be able to get you a better price.
Going solo means you’ll need to find these resources and cover the costs yourself.
Working with a property management company
If you’re not sure that you’re ready to tackle property management or you want to take a back seat approach to your investment, you can have a property manager do the hands-on, day-to-day work.
You could hire a live-in manager, or you could hire a property management company that has a full staff and handles multiple clients.
If you go this route, you’ll pay the company some of the revenue the property generates as a commission. Your daily involvement can be relatively limited, and you’ll collect the remaining revenue as largely passive income.
If neither of these approaches feels right, there is a third option. You could take on a partner to help you manage the property.
Work with a real estate partner
Lots of real estate investors work together to manage properties more efficiently. This can be an informal arrangement, such as between a married couple, or a formal business agreement with a written contract.
However you structure it, your relationship with a real estate partner can streamline your rental property ownership journey – especially if there are gaps in your expertise. A partner can also help you meet funding goals or cover operating expenses as they come up.
Working with a partner usually involves meeting with a lawyer to draft a contract and possibly set up a limited liability company to manage the finances and other property needs. No matter how informal your partnership is, having a contract is important.
Imagine two friends buying a rental house as partners. No matter how close the friendship is, having a contract that outlines each partner’s responsibilities can keep the stress of managing the investment from taking a toll on their relationship.
The Landlord Challenge: The Passive Income You Can’t Get on TikTok
It takes work to succeed at owning an investment property, but the upside is HUGE. The right rental property can generate a decent passive income for many years.
After a while, you save enough money to make a down payment and buy a second property. The increase in revenue makes it easier to save and invest in a third place and then a fourth and so on. Next thing you know, you’ve turned a decent side income into a budding real estate empire.
And, as the loans on the properties get paid down, the equity you earn can build a pretty decent retirement fund.
So, if you’re just getting started, make sure to research and understand what you’re getting into and make informed choices about managing your investment property so you can maximize your ROI.
Fannie Mae. “Eligibility Matrix.” Retrieved January 2022 from https://singlefamily.fanniemae.com/media/20786/display
Office of the Comptroller of the Currency. “Commercial Real Estate Lending.” Retrieved January 2022 https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/commercial-real-estate-lending/pub-ch-commercial-real-estate.pdf