Buying your first rental property can be exciting, confusing, and intimidating, especially if you’ve never done it before and aren’t quite sure what to expect. When you’re getting started in real estate, the scope of possible investments can feel daunting.
Even though figuring out how to buy rental property can be overwhelming, it can be done. The right kind of education is out there to help you become the investor you’ve always wanted to be.
Reasons why rental properties are excellent options
Honestly, there are so many reasons why people get involved with rental properties. Even though they are a lot of work, they can pay off in the end. Here are a few reasons why they’re such good investment options:
Reason #1: Cash flow
First, when you buy the right property, you earn a profit every single month in the form of rental income, known as cash flow. Each property becomes like a small oil well: they pump money 24/7. The more units you have, the more financial freedom you have.
Reason #2: Loan paydown
Second, you use a loan when you add to your real estate portfolio, which means you don’t need all the money upfront. You can even add properties for as little as $0 down.
And here’s the cool thing. Over time, that loan is paid off by your tenants. You might start off owing a large amount, like $200,000, but in 15, 20, or 30 years, that’s paid off by someone else.
Reason #3: Appreciation
Third, rental properties tend to appreciate in value over time, which means while the tenants are paying off the mortgage, the property value is appreciating.
Reason #4: Tax benefits
Fourth, there are many tax benefits that go with owning rentals. It’s possible that you will pay very little in taxes, and sometimes no taxes, on the money that you make from rentals.
How to buy rental property: Start with research
Learning how to buy real estate isn’t a linear process. You don’t go from Point A to Point B but instead, take a number of detours in your education from being a complete novice to buying your first property. Although that journey is different for everyone, there is a certain order of lessons to make your voyage into the world of property ownership as smooth as possible. Consider the following steps:
Step 1: Educate yourself
For a lot of people, this is the hardest part, but it’s a solid and necessary first step in figuring out how to buy a rental property. Keep reading and talking to pros (other investors) and others who are seasoned in the industry. Do everything you can to learn as much as you can so that you feel ready and prepared to make your first investment.
Step 2: Determine your market
It helps to find your first deal locally or only an hour or two away. Dig into websites like Realtor.com and Zillow and also start looking at different properties in your area to see what the prices are. Get a feel for the locations where prices are higher or lower. If possible, connect with other rental property owners in your area to see where they are buying.
You don’t have to invest in your own backyard first when starting out, but it definitely makes the journey a bit easier. However, say you want to buy rentals but you live in downtown San Francisco. You can consider a market farther away. Invest when the numbers make sense with the plan you have.
After you’ve defined your market, do your homework to understand as much as possible about that market. Where do people like to live? Where are property prices higher or lower? What are the rents? What about crime? Talking with local real estate agents, lenders, property managers and other local investors can be tremendously helpful.
When you’re studying what kind of neighborhood you want to invest in, divide them into three classes to make them easier to identify.
- Class A: These neighborhoods include mostly homeowners who typically take a lot of pride in their homes with beautiful upkeep. That won’t translate into it being a good option for a rental property.
- Class B: This is the middle ground among the three classes. These neighborhoods tend to have a wide variety of people and a mix of both renters and homeowners. This is the best class to invest in, and a 35% to 65% ratio of renter to homeowner is the sweet spot.
- Class C: These neighborhoods are mostly rental properties and don’t have the upkeep of those in Class A. These may not be the best neighborhoods to invest in because they tend to have high turnovers, and you’ll learn that constant vacancies cost you a lot of money.
Figure out the money
Step 3: Get preapproved for financing
For your first deal, use a bank or local lender to finance your real estate deal.
They typically require 20% down for a rental property. If you buy a property with multiple units, say a duplex, triplex, or fourplex, and you live in one of the units for a year, you can get a down payment as low as 3%. If you’re qualified to get a VA loan or USDA loan, it could be 0%. Talk with some local lenders to find out what programs they have and what you qualify for. Note that this same method may not work for buying family homes.
If you don’t have enough money to put down, you can try networking with other real estate investors in your area. You might be able to partner with someone on your first deal in that you bring the deal and they bring the down payment. Obviously, that’s a bit trickier to work out than putting down your own money.
When it comes to owning an investment property, your budget involves more than how large a mortgage you can afford. In addition to considering monthly mortgage payments, you also need to keep in mind the ongoing costs of owning and renting out the property—utilities, maintenance and upkeep, taxes, etc. You then need to weigh those costs against how much you realistically expect to collect in rent from your target tenant.
Do a search for comparable rental properties in the areas you’re considering, taking into account the size of the properties and the neighborhoods you’re looking at. This will give you a better feel for average rental prices. You can use some of the BiggerPockets calculators to calculate the cap rate, cash-on-cash return, and other factors.
Step 4: Or, find another investor
This may seem like a hard step, but it can be easier than you think. If you’re telling people about your goals in real estate, it makes sense that they’ll ask you about it. Remember that real estate is a numbers game, and you never know when you will be talking about investing in front of the right person.
Many first-time investors fund properties with private money—that means finding another investor willing to front the money and earn a decent return on their investment.
This is also why it is so important to be educated, committed, and have a strategy. You need to know what you’re talking about and have a plan that people can see will work.
Investors have their own language. It includes terms like “ROI,” “cash-on-cash,” “principal” and “debt service.” You’ll have less trouble finding an investor after you learn the language and speak it.
Some people believe that good deals find money, which is why it’s suggested that you get a deal under contract prior to finding an investor, and not vice versa.
At some point, an investor will want to know how much money they can expect to make. Some investors will talk in terms of capitalization rates, although some will want to know what their cash-on-cash is first.
A cap rate is calculated by dividing the net operating income (NOI) by the all-in price. For example, if the net operating income is $6,100 and the all-in price is $110,000, your cap rate would be about 5.5%. Be conservative in your numbers. Investors will want to know how much you are allotting for vacancy, maintenance, and other expenses. Don’t oversell a deal. It’s far better to under-promise and over-deliver; it’ll make your life easier and help you build long-term relationships with investors.
Step 5: Analyze deals
It may be complicated at first, but you need to start analyzing potential properties, and a lot of them, so you get comfortable with deal analysis. Analyze a few deals every day until you find something you think is right for you.
It’s recommended that you buy 10% to 20% below market. This will allow you to increase your net worth and thus your financial security. If an emergency were to force you to sell your property, you’ll have leeway to decrease your asking price and get through the selling process faster.
Keep in mind there are other aspects to pay attention to when you’re looking for a property. For example, your return on investment, or ROI, should be at least 15%. To determine this figure, use the following formula:
ROI = rent – debt and expenses
Additionally, it’s good to know that rent should be at least 1% of the purchase price. That means if you bought a property for $200,000, the rent should be at least $2,000.
Find the right property
Step 6: Shop for properties
At this point, you know you have to start looking at properties and trying to determine what could work for you based on the numbers.
Most people, especially when first starting out, work with a real estate agent. Look for an agent, and preferably one who understands the investment side of real estate. Ask to receive automatic emails for the kind of properties you want in the areas you’re considering.
You can also research on websites like Realtor.com and Zillow to find out what’s for sale.
Step 7: Make an offer
In a competitive market, you do have to be both fast and smart in the offers you make. You’ll get rejected, and that’s okay. Real estate investment is a numbers game.
You might be accepted 1 out of every 10 or 20 offers you’ll make. The goal is to make sure you’re always making offers on enough properties.
When you do get a property under contract, you’ll pay what’s called earnest money, which is usually around 1% of the purchase price.
Let’s say you are buying a $100,000 property; the earnest money would be $1,000. This is basically your pledge that you won’t walk away from this deal and waste everyone else’s time and effort.
That money is typically refundable only if you either buy the property as promised or back out for a legitimate reason. For example, maybe an inspection found there was a serious water problem in the basement.
Step 8: Do your due diligence
Due diligence is all the work you do between signing the contract and closing the deal.
After your offer is accepted, you’ll need an appraisal and home inspection. The appraisal will provide your lender with an estimate of the home’s current market value. This will cost you approximately $300 to $600.
When you receive your copy of the appraisal, have your real estate agent look it over to make sure the information reported matches up with the comparables in your area. If the appraisal comes back higher than your offer, you’ve got instant equity in the property. If it’s lower, you can withdraw your offer (if it was contingent on appraisal), challenge it, or attempt to renegotiate the contract—all of which are steps your real estate agent can walk you through.
You’ll need to schedule a local property inspector to inspect the property. Your agent will have a good recommendation.
You should always make your offer contingent on a home inspection because it could reveal some potentially serious problems that may change your desire to buy the property at all or cause you to amend your offer. If the home needs significant repairs and updates, you can go back to the seller to renegotiate a price reduction or ask the seller to fix certain issues before the home is sold.
The inspector will conduct a thorough visual examination of everything, from the home’s exterior and interior to its plumbing, electrical, and HVAC systems. The inspector will alert your agent to anything that needs immediate attention (such as mold in the basement, out-of-code wiring, etc.) or may need attention in the future (an aging roof, an inefficient furnace, etc.).
Additionally, your agent’s attorney can help pick a title company, which will be needed for the closing. They will review the property’s title to make sure there are no claims that could affect the legality of your ownership.
If you’re buying a property that already has tenants in it, verify the rental amounts. Verify all the income and verify expenses, too.
If you don’t want to manage the property yourself, hire a property manager during this due diligence time. And, of course, get insurance coverage for the property.
At the end of all that, you’ll sign all the documents, wire the down payment (the bank will wire it in) and then you’ll have closed on your first property. This is all pretty exciting!
How to manage your property
The best deals can be destroyed if you don’t manage the property correctly.
If you’re planning to use a professional property manager, you’ll pay around 10% of the monthly rent for their ongoing fee. If you choose to manage the property yourself, you can save money, but you’ll need knowledge on how to do it. Here are just a few things to know:
- Advertising: No one is going to know how great your property is if you don’t put the news out there.
- Background checks: One way to ensure you have tenants who will cause as little stress as possible is to do background checks before renting to anyone. Make sure you do this before they sign a lease. Doing this beforehand will not only make your life easier but also be better for your other tenants.
- Security deposit: This helps you financially if issues with rent payment occur at the tenant’s end.
- Maintenance: Things will break or malfunction with normal wear and tear. Make sure you have money set aside for these issues.
- Reserves: Maintain six months of cash reserves to account for events such as vacancies, repairs, and more.
Don’t forget about taxes
Like state-specific tax credits available to homeowners, landlords also enjoy tax benefits. Interest, repair costs, and other business overhead turn into tax write-offs, while upgrades, renovations, and the overall home itself turn into depreciation.
While you won’t need to worry about claiming these deductions until tax time, it’s good to be aware of them when you’re considering your overall budget and how affordable a home may be for you.
If you’re considering a major renovation, consider what qualifies as a deduction and what must be depreciated over time. This will make a large impact on your cash flow. Talk to a tax person if you have specific questions.
Brandon Turner is an active real estate investor. “How to Buy Rental Property: 8 Easy Steps for New Investors.” The BiggerPockets Blog | Real Estate Investing & Personal Finance Advice, 27 July 2021, www.biggerpockets.com/guides/how-to-buy-rental-property.