What You Need To Know Before Buying Rental Property
One of the most popular ways to diversify your investments is by buying rental property.
If you haven’t invested in real estate before, it is hard to know where to start and what makes a good rental property investment.
The first thing to know is that you will need 25-30% as a down payment. And finding the right property can be a challenge, but knowing what it will rent for and what all your expected expenses will be is a great start. Plus there are also several 'rules of thumb' that will help ensure you are choosing the right property.
Are Rental Properties A Good Investment?
Just like any other investment, the devil is in the details. Nice property at the wrong price can be a money pit. Similarly, a rental property at a low price could be a money pit that never recovers.
That being said, many investors have created enough passive income with rental properties to retire early and fund a nice lifestyle for themselves and their families.
Prepare Your Finances Before Buying
Before buying rental property, you need to get your finances in order. Buying a rental property is similar to the process of buying your home. However, it is more complicated because of so many extra moving parts.
Boost Your Credit Score
If you’ll be taking out a loan when buying rental property, your credit score needs to be high enough to get approved. Ahead of buying your rental, avoid credit inquiries, pay down your debt, and ensure that you don’t miss any payments.
One trick to boost your credit score is to pay down (or pay off if you can) your credit cards before the statement closes. Not only does this lower your credit utilization, but lower balances also reduce required minimum payments. Those minimum payments are factored into your debt-to-income ratio that underwriters review when approving your loan.
Download a copy of your three credit reports for free at AnnualCreditReport.com. Many online tools and mobile apps also provide free credit reports and scores that give you the resources necessary to improve your score.
Related: 15 Places To Get A Free Credit Score and Credit 101: The Ultimate Guide to Credit in 2022
Save Money To Buy Rental Property
Buying rental property can take a lot of money. Not only do rental property loans require a larger down payment, but you may also need to do repairs before the property can be rented out.
Once you’ve bought the property, you may want to do improvements to make it more competitive or charge higher rent. Examples include adding a bathroom, replacing carpet with tile or wood floors, or adding tile accents in the kitchen or bathroom.
Lenders like to see at least six months of reserves in your bank accounts or investments. This gives them reassurance that you have enough money to carry you through if you lose your job temporarily or can’t find a tenant right away.
Some lenders will include retirement account balances in their calculations.
Assemble Your Documents
Getting a rental property loan is more involved than a normal mortgage. But you’ll need to start out with the basics.
Gather these basic documents to get started:
- Recent pay stubs and W-2s
- Two years of tax returns
- Home mortgage statement
- Property taxes and insurance for residence
- HOA documents (if applicable)
- Bank, investment, and retirement account statements
When you are buying rental property, you’ll also need documents related to your purchase, such as:
- Purchase agreement
- Proof of funds
- Current property tax statement (most can be found online)
- Proposed insurance quote
- Lease agreement (if property is currently rented)
Picking Your Rental Property
Picking the right home or building is key when buying rental property. It is important to do your due diligence before making such a big financial decision.
Location, Location, Location
The location of your rental property is key to a successful purchase.
When researching rental properties, I look for nearby amenities and good schools that will attract the best tenants. Quick freeway access to job centers is also appealing to tenants.
Don’t Fall In Love With It
As much as possible, you want to keep emotions out of your purchase. You won’t be living in this property, so remove your personal tastes out of the equation.
However, use your intuition to find a rental property that will be attractive to a broad range of tenants. Can you add curb appeal? Does the house flow from one room to another? Is there a good place to put a couch and a television in the living room?
Think about what tenants want and compare that to the property you are buying.
Listen: Real Estate Investing Strategies With Paula Pant
It’s All About The Money
Rental property investing is not a charitable endeavor. You want to diversify your assets to minimize volatility in your portfolio and add a new income stream.
Down Payment Required To Buy Rental Property
When buying a rental property, realize that some of the same programs available when buying your home are not applicable to investors. For instance, FHA loans with 3% down are not an option for investor properties.
Most banks require a 25% to 30% down payment when lending on rental properties. On a $100,000 house, that's $25,000 to $30,000.
How Can I Buy An Investment Property With No Money Down?
Let's face it, many people don't have a big chunk of cash available to purchase a rental property. In some cases, you have none. But that doesn't have to stop you from buying a rental property.
There are three factors involved with buying a rental property--time, money, and knowledge. If you have time and knowledge, but don't have the money, find someone who does. There are plenty of investors out there who have money, but not the expertise and time necessary to invest in real estate.
Merging your talents to buy a rental property investment can be a win-win for both of you.
The 1% Rule
When evaluating potential rental properties, keep the 1% Rule in mind.
The 1% Rule states that you should receive at least 1% of the value of the rental property in rent each month. This would give you a 12% gross return (before expenses) on the rental property.
For example, if you buy a rental property for $100,000, the 1% Rule states that you should be receiving at least $1,000 per month in rent.
The 50% Rule
Income is great, but how much of it are you keeping?
The 50% Rule helps you decide whether or not a rental property will be a good investment. Under this rule, no more than 50% of your gross rents (total rent collected) should go towards expenses.
Expenses included in this calculation include taxes, insurance, repairs, property management, eviction costs, turn-over expenses, etc. Do not include your mortgage or other borrowing costs in the first 50%.
Expenses To Consider When Buying Rental Property
To get a better understanding of your rental property expenses, you'll need to do some homework. If the property you want to buy is an existing rental, request a copy of the current year's income statement and the two previous years' full-year income statement. When reviewing the income statements, look for expenses that are outliers or may have spiked.
Rental Property Insurance
Insurance on a rental property is usually more expensive than for a primary residence.
Insurance rates are also much higher when the property is vacant. Vacant properties can attract squatters who may damage the home, and nobody is around to stop a fire or leak quickly in case of an emergency. In these situations, the damage ends up being much worse when the property is vacant vs. occupied.
Contact a local insurance agent to get a quote for insurance. Keep in mind that you may get discounts if your rental property is insured by the same company as your primary residence and automobiles.
Property Taxes
Property tax amounts are public records and can be found online.
Take a look at the rates and adjust if you need to. For example, in California, because of Prop 13, the property taxes the current owner is paying may not be the same amount that you'll pay. Consult with your real estate agent to discuss tax assumptions you should use.
Future Repairs
Even if your rental property is in great shape today, you'll eventually need to spend money. Roofs, plumbing, heating, and air conditioning systems, hot water heaters, and other big-ticket items don't go out every year. Set aside an emergency fund for future rental property repairs so that you're not scrambling for money when they do happen.
Property Manager
Property management expenses are usually 10% of your gross rents. Some property managers are willing to discount this rate when they manage multiple rental properties for you.
Some real estate investors manage their properties themselves. For me, the 10% I pay is worth not having to deal with the hassle of tenants. Finding and vetting them, collecting rents, dealing with repairs, and so on.
A property manager works hard for that 10% of rent. On a $1,000 per month rental, they're doing the job for $100 per month. To me, that's a great deal!
Vacancy
Unfortunately, vacancy is a fact of life in real estate investing.
Vacancy is the term used when you do not have a tenant in place. A rule of thumb is to assume a 10% vacancy rate in your analysis. Again, it may not happen every year, but some years it may take a few months to find the right tenant.
Speak with your property manager about how they will market your rental to minimize vacancy. Do they have a steady stream of prospective tenants ready to go? Will they charge you for advertising to promote your property? Is there a fee for placing a new tenant?
Think through the details of managing a vacancy as thoroughly as you would a property with tenants.
How Much Profit Should You Make On A Rental Property?
Most of my rental properties receive about $1,000 per month in rent. My goal is to earn at least $100 per property after paying the mortgages, all expenses, and saving for future repairs and vacancies. That equates to a 10% profit margin.
Think about how much you're realistically comfortable making on your real estate investment each month. Real estate investing is not a no-risk investment and you need to get paid for taking that risk. If you're not making enough, you might need to sell some properties. In fact, I recently did an analysis of my rental properties and decided to sell a few because they weren't earning an adequate return on my capital.
Related: How To Know When To Sell A Rental Property
House Hacking Strategy When Buying Rental Property
One strategy savvy real estate investors use is called house hacking. It can take many forms, but the basic gist is that you're buying a home with a traditional mortgage and then renting out some or all of your home to tenants.
Some people rent out rooms in their house to friends or strangers while others buy a duplex, triplex, or four-plex to live in one unit while renting out the other units. In the right situation, you could live rent-free (or even make a profit) while your tenants pay your mortgage for you.
The Bottom Line
Buying rental property is a great way to diversify your portfolio and income stream. Smart investments in rental properties will grow your wealth and reduce your risk. But keep in mind all of the expenses and risks associated with real estate investing so that you're not stuck with a money pit.
The right rental property will bring you much closer to Financial Independence with the income that it generates while tenants are paying down your mortgage.
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