For many people, buying an investment property and renting it is one of the most important and significant financial decisions they will make in their lives.
Because of the complicated nature of property investment and the steep price tags most assets command, this decision must be well thought out. There are a variety of factors to keep in mind when investing in rental property for beginners.
In this guide, we'll give you 4 steps to develop a winning rental property investment strategy. Following these steps will give you a head start in making good investments. It will help you avoid the many pitfalls that come with the territory.
1) Know what you are getting into##
Buying an investment property to rent seems like a great idea and it is for the most part. But like everything else in life, you need to be aware of some potential problems and challenges you will face in this journey and realizing this will help you get through them more effectively.
The challenges you might face##
Real estate investments bring a myriad of challenges from finance to geography:
- Very high transaction costs mean that you'll have to pay a bunch of fees to brokers, agents, lenders, and property inspectors not to mention loan payments and the upfront price
- Buying a troubled property could end up being a money sink. If it requires you to throw good money after bad money to fix the problems, it will take a long time to recover your expenses
- Depending on your state and city, the property taxes might eat a large chunk of your profits
- Your tenants might be difficult to deal with and negotiate with
- Legal liabilities like lawsuits and contractual infringement can also become an issue if not careful
These 'disadvantages' are not entirely exclusive to real estate investment - they are a necessary evil when you decide to go into investing of any kind. With rental properties, the stakes are higher than they might be with investment strategies like stock trading because of the moving parts and high entry requirements. Plus stocks are liquid, real estate is not.
Why it's worth buying an investment property##
Real estate investments carry many benefits:
- It can be a good, relatively steady income stream for many years
- Property prices and values do not fluctuate as often or as strong as the stock market that varies by the minute, making real estate more stable and secure
- You can improve your asset through remodeling, to increase its term value in the market
- As inflation increases so does the rent your tenants pay you
- A good asset to have in your investment portfolio for diversification
Buying an investment property before your first home##
One important thing some people might miss as real estate investment beginners is that even though you own the property you can't really live in it. This might be different for properties like a duplex or multi-unit apartment complexes where you might become a live-in landlord. But for the most part, you're putting the whole property up for rent to help give you the highest value of passive income for as long as you own it.
The opportunity cost of this is obviously the fact that you could just buy your own house to live in. If you're already paying a down payment and taking out a mortgage it might as well be for your own home. On the other hand, when you invest in property, you're not necessarily buying it for yourself. You're buying it for the market.
If a particular style of the property or location does not speak to you but is in demand, then it's a good investment opportunity but a bad home for you to live in. Alternately, if your job requires you to spend a year each in different countries, it may still make sense for you to buy an investment property and let it grow while you trot the globe.
This choice varies from person to person and only you can weigh the opportunity cost of spending money on a rental property instead of your own home.
2) Sort out your finances##
Let's start with the real stuff now.
The first and most important thing to do is to make sure you have the finances of your investment sorted. If you need a ballpark figure to aim for then refer to step 3 and then return to this.
Get rid of existing debt##
There's a reason this is the first point we're making.
Pre-existing debt is only going to weigh you down as you start looking at investing in real estate. If you have car loans or credit card debt, then pay that off before deciding to invest. You will probably be getting a mortgage loan. Your monthly mortgage payments along with your other debt will become overwhelming very quickly.
You can still make good investments with preexisting debt but it's going to take a lot more effort and care. Plus your debt to income ratio will impact the amount of your mortgage loan and the down payment required. So, rule of thumb: Get rid of existing debt.
How much should you spend on your first rental property?##
A common question that is very difficult to answer. It entirely depends on your income, job security, your savings, the economy, and the city and area you are looking to invest in. For example, while it's possible to get a house in Ohio for $100,000 a similar house in San Francisco might cost $700,000.
Some low-cost neighborhoods within each city give better cash flow, but appreciate less. Other neighborhoods may be more expensive, give less rental income, but appreciate better. Depending on where you live, you may be able to get cash flow positive properties. In other cases, you may have to go out of state for positive cash flow.
Here's a framework to keep in mind as you make the decision on target purchase price.
- Get pre-qualified from the lender. This will give you a good idea of how much money you need for the down payment and how much loan you qualify for
- Decide whether you want cash flow or appreciation in the short-term. Keep in mind that unlike the stock market, real estate is a long-term play. You are paying commission both when you buy and sell and it will eat into your profits
- Identify the neighborhoods in your target area that will help you achieve one of the above two goals
- Estimate the house prices - look at Zillow, Redfin, Trulia, MLS to see what you can get for the money
- Talk to realtors to get an idea of the locations. Some realtors are better at investment properties than others
- Visit the properties and locations. Nothing beats seeing things in person. Examine the condition of the property to see how much work will be required to bring it up to snuff
- Understand the target tenants for your area, the demographics, their likelihood of paying rent, the likelihood of them being long-term tenants, etc.
With these, you can identify the purchase price of the house, the locations where it is possible to achieve your cash flow or appreciation goals, the target demographics, etc. Some locations may offer you both cash flow and appreciation in the short-term.
Refer to step 4 for more information on how you can capitalize on this.
Lenders generally ask for a higher down payment for investment properties than for a primary residence. You likely have to shell out at least 10-25% of the purchase price upfront and finance the rest through mortgage loan. Coming up with this money may also increase your chances of getting the mortgage loan in the first place - the lenders think that you are less likely to walk away from the property if you have some equity. The amount of the down payment will vary greatly depending on the size and location of your potential investment. For example, while you'll need $20,000 for the house in Ohio, you'll need $140,000 as a down payment for a comparable house in San Francisco.
If you're new to investing, then a good place to start is by just putting aside a certain amount of money each month until you save up enough to get there. This amount depends on your income and the other expenditures you might have. We recommend investing in mutual funds until you save up enough for the down payment.
You can also take out a second loan, also called as the line of credit, for the down payment to actually qualify for the mortgage. While this can help you get started with real estate investing, you usually end up paying higher interest on this second loan. You have to factor in the extra payments for your second loan along with your new mortgage. Depending on the cash flow and your personal financial situation, this can get quite overwhelming especially in the beginning.
Getting a mortgage##
The next step is to finance the rest of the value of your house through a mortgage. A mortgage breaks up your house payments into small chunks that you pay for 10 to 30 years depending on the initial terms of your loan.
There are basically two types of interest rates you should be aware of when deciding to choose how to pay your mortgage: fixed interest rates and variable interest rates. Fixed interest rate loans keep the interest rate constant throughout the years of repayment while variable interest rate loans change according to the economy and usually fluctuates between high and low cycles. The yearly variable interest rate = the prime interest rate + fixed percentage set by the lender during the loan agreement.
There are distinct advantages and disadvantages of each, and you can read about it in more detail in our 'buy or rent' guide.
This step ties into the first one and many expert investors would probably make researching your property and the market the number one point to focus on before buying any rental property.
Determine what makes a good rental property##
Before owning a profitable rental property, you have to find it.
Several factors go into this decision and some notable ones include:
- The neighborhood and location of your property
- Nearby amenities like schools, shopping malls, fitness centers
- The crime rate and security of the area
- Proximity to business centers
- Condition of the property itself
- Potential for future growth
- Average rent and property prices and taxes
- The average income of residents living in the area
Find good deals##
Look at alternate ways of finding properties cheap. Wholesale, auctions, etc., are some options. This is a great strategy to get by with little money and score a great deal on your first real estate investment.
Check the outskirts of your city or less expensive areas where the property prices might be lower. The local demand for property will still be high in the outskirts and suburbs. However, the distance from the city center may keep the price lower, making it easier for you to invest.
Finding slightly worn down properties in nice areas of a city is another great way to save money on the initial investment. The price will be lower if the drywall has some holes or if the floor needs replacing. The trick is to buy it cheap and then renovate it to increase the value.
However, you have to be careful when you're assessing this. You don't want to buy properties that have big problems like foundation or structural issues that are more expensive to fix than a simple drywall or floor change. Those costs need to be factored in too.
4) Legality and procedures##
The last step is the icing on the real estate cake.
You've saved up, you've researched long and hard and are finally honing in on your first rental property. Now it's time to quite literally seal the deal.
The first step is to make the offer to the property owner. You can do this with a real estate agent who will be your guide through this whole process. Choose a good real estate agent who has a proven track record and is honest about the pros and cons of the property and the location. They might be more expensive, but they will save you from bad deals which can be much more expensive in the long run. They could also assist you in getting future tenants.
You'll have to factor the insurance costs, closing costs, property taxes, HOA fees, etc. Your agent will be instrumental in guiding you through these legalities. You might also want to get a professional property inspector to identify any potential problems.
If all goes well, you'll have to decide on whether you want to be manage the property yourself or hire a property manager. For the average new rental property buyer, managers will be an extra expense. Managing the property yourself is possible with the help of the right tools. HomeKasa offers the best property management software and it is free. You can use that to look at the profit and loss statements and evaluate how your property is working for you.
We hope these steps guide you on the purchase of your first rental property. Be sure to check out the rest of our blog where we discuss real estate investments and give helpful advice and tips on a myriad of related topics.
Our software HomeKasa makes it easy to manage multiple properties, screen tenants, manage property documents, handle move-in and move-out inspections, and collect rents all from one place.
Lastly, just remember to always think rationally and don't make an emotional decision on your investment property. Relax and enjoy the process. Think with your brain and your wallet will thank you!