What You Should Know Before Buying Rental Property
We’ve all been there: You go on vacation to a popular spot, look around, and think: These local homeowners must be making a fortune on renters!
Buying the right kind of rental property can definitely generate a healthy cash flow. In fact, it’s one of the best ways to make money in real estate and it can be an excellent investment strategy. If you can find a gem of a property in a popular area that is full of tourists, you should consider jumping on the opportunity if you are able.
For example, by becoming the property owner of one or two single-family homes in a popular vacation destination, you can open up steady streams of income that can help you accomplish your long-term financial goals. With that in mind, get ready to learn everything there is to know about buying a rental property on your journey to financial independence.
The Beginner’s Guide to Rental Buying Rental Property
What Is a Rental Property?
A rental property is a type of property that you purchase with the intention of making it available to renters throughout the year.
In other words, a rental property is not meant to be your primary residence. Rather, it’s an investment property that’s meant for short- to medium-term renting (everywhere between long weekends to months-long stays). The point of a rental property is to generate enough rental income to make your mortgage payments so that you at least break even for the majority of the year and have enough left over to pay income tax obligations.
That said, you can certainly stay in your own rental property from time to time. In fact, you can even make it available to friends or family.
Here’s a tip: Since you’ll be running this like a business, you may want to consider charging friends or family to stay at your property. There is nothing wrong with doing this. Many people choose to provide family discounts. In other words, just because you own the place doesn’t mean you should consistently offer freebies. You’ll still have to pay for upkeep and maintenance to avoid incurring hefty depreciation on your property.
How to Get a Mortgage for Your First Rental Property
The first thing that you’ll want to do is find a savvy and trustworthy real estate agent who is licensed and accredited in the area where you are looking.
This part is important: Avoid signing a contract with a real estate agent that you don’t know if at all possible. The real estate agent is going to play a significant role in buying the property and helping you get a low interest rate by matching you with the right lender. As such, it’s in your best interest to find someone who acts in your best interest. If you don’t know anyone in the area, spend some time there first and try to ask someone for a personal recommendation. It’s still not optimal. But it’s better than going in cold.
Once you find a trustworthy real estate agent, they are going to be able to help you go through the financial process. If you already have a mortgage, make sure to tell this to the real estate agent or the lender that they set you up with. Lenders tend to have different rules outlining specific requirements for second mortgages.
Keep in mind that the top two things that lenders look for when deciding whether to give a second mortgage to someone is a decent credit score and a debt to income ratio that’s 43% or less. Lenders, after all, want to make sure that you’ll be in a position to make the monthly payments on time.
Here’s the good news: You may be able to use your house as collateral and even consolidate your monthly payments into one easy monthly payment to secure a second mortgage. So, don’t be afraid to talk to the lender about your financial situation to see how they can accommodate you.
Once you get prequalified for your second mortgage, ask for an offer in writing. Then shop around for other lenders who may be able to give you a better interest rate.
It’s also important to remember that getting prequalified for a loan is not the same as getting preapproved. Prequalification provides an estimate of what you’ll be allowed to borrow. Preapproval lets you know exactly what you are allowed to borrow when buying a rental property.
You can also check out my full post on how to get a mortgage for a rental property.
Why Your Home is Not an Investment Property
One thing that homebuyers quickly realize is that their primary residence is not an investment and it shouldn’t be treated like one.
A home is not an investment for a few reasons. First and foremost, selling a home at market value and getting your money’s worth can take a long time and a lot of work. Most people are not in a position to move quickly and jump during a seller’s market.
More importantly, home equity does not build interest. In other words, as you pay down your mortgage, the equity you collect won’t affect the value of the house. As such, paying down your mortgage or even jumping into another house is not going to make you money. That is, unless you significantly downsize, sell your home well above market value and make a large profit, or move to a location where you can get more for your money.
Making Your Home Available to Renters
All this being said, you can make your home more of an investment by converting an area of your house into a place that accommodates guests from sites like Airbnb — like a spare bedroom, a garage, or an unused area of the house.
This strategy can be a fun way to meet people while also making a few extra dollars per month. Granted, the downside is that you have to deal with guests and accommodate them. But if you vet the person ahead of time and they seem nice, it can be a great way to pay down your mortgage faster.
The Benefits of Rental Properties
There are many benefits to buying rental properties. In fact, rental properties can be a great investment that delivers a solid cash-on-cash return. Here’s why.
You Can Make a Lot of Money
One of the top reasons to buy a rental property is that you can make a lot of money on your initial down payment.
For example, suppose you put down $20,000 for a rental property in a strategic location. As long as you can bring in a steady volume of renters, you can pay down the mortgage over time. In most cases, rental property homeowners try to at least break even on their mortgage for the first several years.
And if the property is in a great location, chances are its value will improve over time. Should that happen, you could ultimately decide to sell your property for a sizeable gain.
As you can see, rental properties can be an excellent source of passive income, giving you a steady positive monthly cash flow.
You Can Outsource Property Management
Another great part about purchasing a rental property is that you don’t have to actively manage it if you don’t want to. Instead, you can hire a management company to book guests, clean up after them, and deal with renters. You can also partner with a realtor to match renters with your property.
Once you have guests, it is highly recommended that you use a management company for your rental property. For most people, it’s worth the cost to avoid handling the hassle yourself.
If you hire a property manager, just keep in mind that there are several fees to consider. You’ll usually have to pay for setting up your account, ongoing monthly management, leasing, renewal, and maintenance.
This shouldn’t deter you from renting. But make sure to shop around and find a rental management provider that is going to charge reasonable rates. Don’t be afraid to negotiate, either.
What’s more, you should make sure to scout out available options before purchasing a property. The last thing you want to do is purchase a property and find out there are a limited number of management options in the area.
Of course, you can always choose to manage the property yourself if you don’t want to pay for a company or work with a realtor. But you’ll have to do a lot more work. If you choose to work with a property manager and realtor, you can benefit from a turnkey service where you’re just collecting money at the end of each month.
Top Rental Property Costs to Consider
Buying a rental property can be very expensive. As such, you’ll need to have plenty of money put aside to cover costs.
Expect to put down at least 20% when buying a rental property. That way, you can avoid paying private mortgage insurance (PMI) and preserve the margins on your property because of it.
Pro Tip: There are some ways to buy a house with no money down, but these are only available in certain scenarios.
The amount you’ll have to put down will depend on the cost of the property, what you can afford, and the type of loan you qualify for. If you have an excellent credit score, you may be able to put less down than someone whose score leaves much to be desired.
To protect yourself in the event something bad happens on your property, you’re going to need homeowners insurance. It’s virtually impossible to secure financing without it. Further, if you put down less than 20%, you’ll also have to cover PMI as well.
Taxes can vary depending on the state and town where you purchase your property. However, if you receive rental income from your property, you may be able to deduct certain rental expenses on your tax return like mortgage interest, operating expenses, property taxes, and repairs to lower your effective tax rate.
Talk to a financial advisor about tax benefits to confirm what you are eligible to deduct.
Don’t get caught off guard about closing costs for your rental property. Average closing costs can be as much as 2% to 6% of the total price of the investment property, which is a sizeable amount, particularly as property values climb higher. This being the case, you should always enter the home-buying process with more money than you need.
At the same time, don’t be afraid to negotiate closing costs. You may be able to wrap these into the total cost of the loan or even have the seller pay for them. This is where it pays to have a savvy rental agent who can try and work with the seller to be flexible.
Tips for Buying Rental Property Real Estate
Be Strategic About Buying Your First Rental Property
Don’t sign your name on the contract and move forward with your rental property until you’re completely confident about the place you’re buying, rental demand, and your ability to make money from it. After all, sometimes the best deal is the one you walk away from.
Location Means Everything
Make sure to investigate the annual vacancy rates for the area that you’re looking into. Generally speaking, a vacancy rate of less than 3% is considered to be a landlord’s market.
You’ll want to analyze year-round vacancy rates, too, in order to make sure you can fill spots during potential off-seasons. For example, a ski town may be booming during the winter but how does it fare during the spring, summer, and fall? You don’t want to get stuck with a piece of property you can’t easily rent for three-quarters of the year. Otherwise, you’ll have trouble coming up with the operating income needed to keep the lights on.
If you are looking at a seasonal location, figure out if you can make enough on your rental property during the peak times to cover for the months where it could sit vacant.
Learn More: Cheapest States to Buy a House
Do Your Due Diligence Before Buying
Take a hard look at the expected expenses that go into your monthly payment. One thing you’ll want to look into is the homeowners association (HOA) fee if you’re looking into an apartment or condo. This can be several hundred dollars per month and can seriously drive up the cost of your monthly payments.
Ultimately, there is a lot to consider when buying a rental property — like the quality of the town (including the bar and restaurant scene), the property’s proximity to local destinations, rules, and regulations for the unit that you’re purchasing, the amount of work that the place needs, and more. Take your time and survey your options, and you’ll make the right choice.
Learn More: Rental Property Due Diligence Checklist
Rental Properties vs. REITs
As you go through the process of buying a rental property, you may find that you lack the necessary resources to execute the deal. And that’s fine because you can still profit from real estate by investing in the stock market through a real estate investment trust (REIT).
What is a REIT?
A REIT is a type of investment offered by a property management company that owns or finances income-generating properties.
By investing in a REIT, you can buy stock in a real estate company and profit in a similar way to owning the property outright. The benefit is that you don’t have to worry about tenants or management companies or even maintaining any properties.
This is purely an investment that can be bought or sold through a stock exchange. It’s infinitely easier and it can be just as profitable, particularly when REITs pay out high dividends. Over time, a high-quality REIT can be more lucrative, and far less trouble, than a rental property.
Learn more: Are REITs a Good Investment?
Is real estate investing a smart move?
Real estate investing can be a smart move, but it’s not a surefire way to ensure financial success. It all depends on the property that you purchase, how well you negotiate during the sale, and how you manage the property.
If you find a great deal on a property in an excellent area, buying a rental property can be one of the best financial moves of your life. On the flip side, the wrong move can ruin you financially. Do your due diligence before buying a rental property. Otherwise, you may regret it.
Are rental property mortgages more expensive?
Mortgage rates are usually higher on investment properties because you won’t be living there full-time. As such, don’t be dismayed if the rate that you get from the bank is significantly more expensive than a previous loan that you received on a house — especially if this is your first rental.
There are many different types of mortgages to choose from, so determine which best suits your needs.
Should I pay off my mortgage?
Remember that, as an investor, mortgages are your friend — even if you’re trying to make a profit. You can receive hundreds of thousands of dollars at a low interest rate, with many years to pay it off. In addition, you can take the money that you receive in income, pay it down, and invest the rest. Since equity does not generate interest, it might make more sense to keep your mortgage for as long as possible.
Should I use a property manager?
If you are thinking of buying an investment property to rent, you should absolutely consider using a property manager unless you have the time and energy to treat renting as a full-time job. This includes filling vacancies, performing maintenance and upkeep, dealing with tenants, and so on. The vast majority of rental owners use property managers even if they cost a lot of money. Take my word for it: Peace of mind is usually worth every penny.
Is it better to rent or flip a property?
It largely depends on your financial goals. In general, buying a fixer-upper and flipping a house for profit can earn a lot of money in a short period and can be a great investment strategy. However, it can also take a lot of time and require spending a large amount of capital. Renting a property is more of a long-term investment that generates a steadier return at a slower rate.
Learn more: Best Books on Flipping Houses
What’s a cap rate?
A capitalization or cap rate is a financial term that’s used to describe the rate of return on a real estate investment property. A decent cap rate for a rental property is usually between 4% and 10%.
Investors sometimes refer to the 2% rule in real estate. In other words, a rental property can be considered a good investment if monthly income is equal to or exceeds 2% of the purchase price.
The Bottom Line
Buying a rental property as an investment is a major decision that you should weigh carefully. Make sure that you have the resources in place to devote to this process or you are going to have trouble making ends meet with two mortgages and all of the other expenses that go into the process.
If you think that you are not in a position to buy a rental property, consider starting with a REIT. This strategy can still make you a lot of money and it does not come with any of the hassles of homeownership. Plus, you can sell your position at any time, which isn’t always possible when you own a property outright.
If you are in a position to move forward with a single-family or multi-family home, look for a place that can generate a positive cash flow. This can be one of the best ways to make money in real estate.
If you can find a place with great property value in a popular area that is full of potential renters, and you think it can generate a strong return on investment, jump on the opportunity if you are able and begin your journey as a real estate investor.