Are you thinking about buying an investment property? Many of the wealthiest people in the world have made real estate one of their prime investment choices. Experts agree that it is better to have a solid understanding of the subject before you invest hundreds of thousands of dollars. This article explores the key factors to consider when buying your first rental property.
Statistica reports that in 2019, there were 14.5 households, 44 million residents, renting single-family homes in the U.S. Urban.org predicts a 21% rise in new rental households between 2020-2040.
Although single-family rentals can often generate strong, steady cash flows, it can take a lot of time and hard work to own rental real estate. Below we will go into if investing in rental real estate is right for you.
Are you cut out to be a landlord?
Although it can be a great way to make a living from real estate, it is not glamorous. There are many maintenance headaches and hassles that come with selecting the right property and prepping the unit for tenants.
Are you able to use a toolbox full of tools and know what each one is for? Do you know how to fix drywall? You could call someone to fix it, or you could hire a property management company. However, this will reduce your profit margins. To save money, some property owners who own multiple properties often repair their homes themselves to save money. Although this strategy leads to another problem….not enough time.
However, not everyone is cut out for being a landlord. This is a demanding and time-consuming job, especially if your day job is already full-time. This is why it could be a good choice to hire a management company to handle this job.
Is rental property the best choice?
Now, we’ll go over the basics of buying rental property. It is important to consider whether renting a property is the right choice for you.
The Internal Revenue Service may classify rental income as a passive activity; however, real estate investments require active participation and a willingness to take on risk in return for higher potential rewards. You need to be careful however, you may want to read our article 11 mistakes made by first time landlords to avoid some of the pitfalls.
Real estate investors may need to continue oversight of their investments even if they hire local property managers. Investors may have to approve certain repairs or improvements and review their financial statements monthly and annually, including the income statement, net cash flow report, and annual reconciliations.
Even with the best tenant screening, investors may find themselves with tenants who pay late rent or need to be evicted. Evictions can lead to lost rental income, which can quickly reduce potential profits and lower overall returns. It can also be costly and time-consuming to manage the eviction process.
A good investment property can offer recurring rental income and long-term appreciation in property values. Tax benefits are also available by deducting operating expenses and owner expenses and depreciation.
However, savvy investors consider the risks and benefits of investing before they make a move.
When to hire a property manager
Should I hire a property management company? A property manager can be hired to manage rental properties. This can be difficult because property managers charge anywhere from 8% to 12% of the rent collected.
However, it is worth hiring a professional property manager for several reasons. You will have less work and headaches if you use their industry knowledge. A property manager will generally:
- Know how to market your property
- Know the local rental market and ensure that you price your rental appropriately
- Let potential tenants see the property
- Screen tenants (for instance, run credit checks and verify references)
- Collect the rents and deposit them into your bank account
- Manage late rents and navigate the process of eviction, if necessary
- Handle tenant complaints
- Arrange maintenance and repairs
- Manage property-related bills such as property taxes, utility bills, and insurance
These questions will help you decide if hiring property managers is financially prudent
- Can I manage the property on my own? You may not have the energy or time to manage a property if you work a full-time job. This is particularly true if you have multiple properties.
- Is the rental property located near my house? Living far away from your rental property takes up more of your time and may make it harder to handle routine and urgent matters.
- Do I have the ability to deal with tenants? Even if your screening is excellent, you will likely have to deal with some tenants who are unreasonable, pay rent late, or need to be evicted. Are you willing to deal with these tenants?
- Are my rentals for long-term or short-term tenants? If you’re looking for long-term tenants, it might be slightly easier to manage the rental property yourself. If it is a short-term rental you will have to deal with multiple tenants and potentially many maintenance issues.
- Do I need control of the property? If you find it difficult to hand over tasks such as selecting tenants or performing maintenance tasks you may want to manage the property yourself.
How to get a mortgage for an investment property
The big question that people have when buying a property is “How much am I able to afford?” This can be determined by using the anticipated rates and monthly payments. You can then get pre-approved to find out how much money you are eligible for. Your home loan expert should know that you are interested in purchasing an investment property. These properties have different rules than primary residences.
Get pre-approved first
Searching for a property prior to securing financing is one of the biggest mistakes homebuyers make. Let’s suppose that you have spent months searching for the perfect rental property. The property may already be under contract with another buyer by the time that you get approved for mortgage financing. You can get pre-approved right away and then be ready to grab a great deal in a flash.
The problem with looking before you are pre-approved is that you don’t know how much you can qualify for. It would be heartbreaking to look at properties in a certain price range only to discover that you are eligible for less than you anticipated. Pre-approval allows you to make informed decisions about the investment property that you want to purchase.
Locate a rental property
Choosing the right rental property or the best real estate market is only one of the many factors you should consider.
- Employment and population growth
- Ten percent of households occupied by renters
- Rising rent prices and falling vacancy rates
- Long-term appreciation may be possible due to historic changes in home values
- Rating of the neighborhood, including quality school districts and employment rates
- A turnkey single-family rental property that has a tenant (or a home ready to rent) is an option. This helps reduce the risk for first-time investors.
- The rates of property tax can differ from one state to another, which can have a significant impact on your potential ROI.
You can find a house for sale online at many places, such as Zillow, Trulia, and Realtor.com. However, most listings are only for people looking to purchase a primary residence.
How do I determine the potential ROI of my rental property?
The first thing you should ask when looking for great investment properties is “Can it actually make money?” You can calculate the return-on-investment (ROI) to determine how much your property could make.
To calculate ROI, first figure out the property’s annual net income. This is the amount of rent money left after paying the taxes, insurance, property management fee, expected repairs (plan for 1% of the property’s value), possible vacancy periods, HOA dues (if applicable), and any other utilities not covered by the tenant.
Divide the annual net income by the amount spent on the property to calculate the ROI. If the net annual income is $7500 and the property cost $100,000, the ROI would be 7.5%.
What makes a good investment property?
To determine if the property is a good investment, you need to look at certain criteria when searching neighborhoods for your first rental. You want a property with low maintenance, few vacancies, and a high rent-to-value ratio.
A fixer-upper is one of the most common mistakes made by first-time landlords. Don’t buy a property that “needs a lot of TLC”. There are few things worse than realizing your cash cow is actually a money pit.
The only exception might be if you are skilled in home repairs. You may be able to do large-scale repairs more efficiently if you are a skilled handyman or know someone who is. It’s generally easier to buy a house that is in good condition than to fix one up. Do your best to resist the temptation of a fixer-upper.
Your investment property won’t be worth much if it doesn’t have any paying tenants. Your property should be attractive not just to any tenant but specifically to tenants who are punctual with rent and won’t destroy your property.
Depending on where you live, certain places have lower rates of vacancy. This is the case for San Jose, CA and Fort Collins, CO. Both of these cities had a 0.2% rate of vacancy in 2016. While you can do online research about the area in which you are interested, it is best to spend some time driving through the streets around your potential property. You can get a good idea of the type of renters in a home or community simply by looking at how the properties are taken care of.
The 1% Rule
New investors often ask the question, “How much should I rent my property for?” Seasoned investors use the 1% rule, which says that rent should not go below 1% of the purchase price. If you bought a house for $100,000 you would have to rent it out for at least $1,000. Some investors may not always agree with this and will accept a lower return.
To ensure that your potential property is able to receive the same return as other properties in the area, get rental estimates. This gives you an idea of what a reasonable rental rate would be.
The bottom line on buying your first rental property
Be realistic about your expectations. Renting property won’t bring you a huge monthly income immediately. However, renting properties can still be a great way to invest in real estate.
There are many factors to consider when buying your first investment property. It is important, however, that you do your research. Start saving money for your down payment and looking at the housing market and the neighborhoods.
Consider working with an experienced partner to buy your first rental property. You can also rent your home out for a time to see if you are a good landlord.