Purchasing a rental property can be a lucrative investment. It can be a passive source of income: With a little effort, you can bring in money from tenants.
Is this your first venture into investment real estate and not sure where to start? We’ll help you through the initial steps of buying your first rental property with 11 tips.
1. Decide How Hands-On You Want to Be
Before purchasing a rental property, decide whether you can handle being a landlord. Consider your time and abilities. Are you savvy at fixing a leaking pipe or unclogging a drain? How do you feel about taking emergency calls about pest problems at midnight?
If you prefer to delegate those matters to a property management company, you’ll need to factor in that cost — and make sure it doesn’t exceed the income you bring in.
2. Use Leverage to Fund Real Estate
Using borrowed money can help you to afford a property that you can’t pay for outright. Getting the best mortgage will help to free up cash for maintenance and repairs.
Are you looking to buy your first rental property with no money for the down payment? You may be in luck. If you already own your own house and it has been increasing in value, you can tap your home’s equity and use it as the down payment for the rental property.
3. Determine Your Financing Options
Before diving into the rental market, make sure you know what you can afford. Qualifying for a mortgage for a rental property can be more complicated than for a loan for a home you live in. (It’s also unlike a commercial real estate loan). Why is that?
Loan Options Differ
Government-backed loans aren’t available unless you buy a multi-unit residence and live in one of the units. Simply put, the fantastic loan you secured for your home may not be available for a rental property.
You Need More Savings
Since you’ll likely buy a home before investing in rental property, you’ll need to be able to qualify for 2 home loans at the same time. Your income needs to be higher than when you qualified for the mortgage to purchase the home you live in. As a rule, the borrower needs to prove they have enough money to cover 3-6 months of expenses in checking, savings or retirement accounts after you purchase the rental property.
Interest Rates May Be Higher
Because it’s a more significant risk to the bank compared with a standard home mortgage, the interest rate on your investment mortgage will likely be higher. The lender wants to make sure that you won’t just walk away from the investment. Landlords typically add this to the rent, but make sure you can cover a higher interest rate if you don’t have tenants in place.
4. Put Enough Money Down
A mortgage on a rental property can’t be insured, so lenders generally require more money down. Although you can get a private home loan with as little as 3% down, a rental property requires closer to 20% for the down payment.
Lenders are more skeptical of rental property mortgages because they are a bigger risk, so you’ll likely need 20% down before you can qualify for a mortgage.
5. Focus on Single-Family Homes
For your first rental property, it’s best to buy a single-family home rather than a property with multiple units. Having one tenant will decrease the stress and amount of work that goes into managing the property while you try on those new landlord shoes. A single-family home in a thriving neighborhood is a sought-after rental, so you should have no problems finding tenants.
6. Purchase Turnkey Property
A turnkey home is a dwelling that is 100% ready to live in. In other words, it’s all set for a tenant to turn the key and move in their belongings. Buying a rental property that’s ready to go lessens the risk of the units sitting empty while under repair or renovation, which lowers your return on investment.
7. Calculate Your Return on Investment
Before buying a property, you’ll want to figure out the capitalization rate (cap rate for short). This will help you to determine how profitable a property can be for you.
How to Find a Cap Rate
To find the cap rate, calculate your net operating income. Your net operating income is your expected annual income from the rental units minus anticipated expenses, such as maintenance and landscaping. Next, determine the current market value of the property. Divide your net operating income by the current market value, and you have your cap rate.
What’s a Good Cap Rate?
You’ll want a cap rate of 7% or higher. If the cap rate you calculate is lower than this, reconsider the purchase or talk to a professional for guidance.
8. Plan for Extras
Just like your home, a rental property requires more than merely paying the mortgage every month. Some extras can sneak up on you if you don’t plan for them. Don’t forget to consider these operating costs:
When you own a rental property, you’ll need landlord insurance to decrease your risk since you aren’t living in the residence. Basic landlord insurance policies cover fire, theft, wind and ice damage. These policies can cost you 15%-20% more than standard homeowner insurance.
It’s a good idea to require tenants to purchase their renter insurance so their personal property is covered.
Property taxes vary by state, falling anywhere from 0.27% to 2.44%, depending on where the property resides.
You’ll want to maintain your property to keep your tenants happy and to make sure they stick around. These expenses include the repair or replacement of appliances, plumbing and electrical costs, landscaping fees and trash collection. Factor these costs into your ongoing expenses.
Homeowner Association Fees
This fee doesn’t apply to all properties. But if your neighborhood has a homeowner association, remember to calculate those monthly fees into the total cost of operations.
9. Create a Marketing Plan
What is the most important thing you’ll need after purchasing a rental property? Tenants.
To find good, reliable people to move into your units and pay monthly rent, you’ll have to build a marketing strategy.
Target your market. Would it help to post in the newspaper or on a bulletin board at a local coffee shop? Marketing online may get you the most responses. Post on rental sites such as Zillow or Cozy or on social media.
10. Visit the Neighborhood
Don’t rely on photographs or online accounts of the neighborhood. Go there yourself. Take a tour of the community during the day and at night to scan for any potential safety concerns.
Chat with neighbors and let them know you are considering purchasing a nearby property. Ask questions about the school district, crime rate and local amenities. People who live there know the ins and outs of the neighborhood more intimately than an online listing.
11. Draw Up a Legal Rental Agreement
When you decide to take on tenants, you’ll need to offer a lease. This legal agreement should include information such as late payment fees, pet allowances and penalties for early lease termination. Without a legally binding contract, you are putting yourself at risk for a tenant to abandon the property and leave you with little or no recourse.
Be sure your tenant signs the lease before move-in day.
Buying your first rental property isn’t a decision to take lightly. But if you do the research and heed our tips, it can be a rewarding one.