If you’re thinking about buying your first rental property, you’ve got a major decision on your hands. Rental property has the potential to be a great investment that increases your cash flow and net a nice chunk of change when you sell in the future. You may have even read the statistic that real estate created 90% of the world’s millionaires.
The reality is that owning rental property is much more complicated than it looks, which is why you need to be as prepared as possible before investing. The tips below will help you prepare, research, and determine if buying an investment property is right for you.
10 Tips for Buying Your First Rental Property in
1. Make sure you’re financially stable
Financial stability is a must if you’re considering buying rental property. It’s not uncommon for real estate investors to carry debt as part of their strategy. Still, the average investor should have very minimal debt, if any, before buying an investment property.
Debt like student loans, a mortgage, a car loan, personal loans, unpaid medical bills, and credit card debt should all be considered. High-interest rate debt especially should be paid down before you get too serious about buying a rental property. Debt is a liability that can make it incredibly difficult for you to have the cash you need to deal with unexpected rental expenses.
You’ll also want to make sure you have a solid emergency fund and are on track for retirement. Buying and renting houses can generate a steady income stream, but it’s too risky to stake your future on rental property alone.
2. Understand what it’s like to be a landlord
Have you seriously thought about what it would be like to be a landlord? For example, how will you respond to a 3 a.m. call about a clogged toilet? How will you handle renters who are late with rent? Even if you are thinking about using a property manager (more on this shortly), you’ll want to think about what it would be like to be a landlord because you may need to fill that role at some point in your rental journey.
Landlords do a considerable amount of work — running background checks, collecting rent, playing the role of handyman and cleaner, etc. And your renters will expect you to be on-call for them whenever something happens.
Not only will you be on-call and making tough decisions about your property, you also have to make those decisions pretty quickly because you’re in charge of where someone else lives.
The reality is that not everyone is cut out to be a landlord, and that’s okay. There are other ways to invest in real estate without being as hands-on, and it’s better to realize that from the beginning. You can use a property manager (as long as you budget for it), or you can check out crowdfunded real estate, which is a much more passive form of investing.
3. Know the location
You know the saying, “location, location, location.” And that’s definitely true for rental properties. However, the key to buying an investment property is to find something that offers solid cash flow while also not being too expensive.
The ideal location for most property owners is an up-and-coming city. You can look at factors like population growth or local revitalization efforts. Those are signs of potential and can help you with more than just cash flow. These are properties that stand to appreciate over time, for a solid long-term return on your investment.
You don’t necessarily need to live in the same city as your rental property, but you can get a feel for the place you’re considering buying rental property by looking at the school district, access to public transportation, growing job market, low property taxes, low crime rate, and amenities that will draw in new residents.
4. Buy or finance?
There are two schools of thought when purchasing a rental property: pay cash or take out a mortgage. You need to consider your investing goals to figure out what’s right for you.
Here’s what I mean: If you pay cash for a rental, you won’t have a monthly mortgage payment, meaning the rent you collect is almost all positive cash flow. A cash buyer sees a higher annual return on their investment because they don’t have as many expenses.
An example of that scenario is purchasing a rental property for $100,000 in cash. You generate $12,000 annually from rent, which equals about $9,500 in annual earning after factoring in taxes and depreciation. That equals an annual return of about 9.5%.
On the flip side, buying rental property with a mortgage uses leverage to potentially magnify your return. Your monthly cash flow decreases, but your cash return can be significantly higher in the long term.
Using the same example as before, let’s assume you’ve taken a mortgage out this time. With a 20% downpayment and a mortgage that compounds at 4%, you’re earning around $5,580 annually after expenses. It’s less cash each month, but your annual return equals just over 27%.
A mortgage yields a higher return, but it means you can end up in a tough spot if your tenant can’t make rent. This is why it’s so important to be a solid financial ground before buying rental property.
5. Budget for unexpected expenses
If potential property owners can glean anything from 2020, it’s that you must prepare for the unexpected, and most owners underestimate the amount they need to budget for.. You need to not only save for maintenance, upkeep, and emergency repair, you need to save for the possibility that your renter won’t be able to make rent for months at a time.
Most experts suggest saving 20% to 30% of your rental income to cover inevitable expenses. You’ll need to set that aside each month because not budgeting enough can lead to a financial disaster.
Hopefully, what happened in 2020 with the eviction moratorium will be a one-time event, but it’s taught us that really anything can happen. The best way to protect your investment is to be prepared.
6. Avoid a fixer-upper
Fixer-uppers look appealing on TV, but the reality is usually much more costly and time-consuming than the average property owner can handle. You’ll undoubtedly see several houses that look like bargains that you can flip, but it’s generally a bad idea for your first rental. This is especially true if you lack the time, experience, or funds required to take on that kind of project.
Looking for properties that require minor repairs is much better for new investors. You’ll end up getting a renter much faster, which means you’ll see a faster return on your investment.
7. Have a long-term outlook
Like most investments, buying rental property require that you plan for a multi-year commitment. The longer you can collect rent and see your property appreciate in value, the better your return.
The same logic is why crowdfunded real estate platforms like Fundrise or CrowdStreet don’t let you redeem the full value of your shares for five years. You need to pay down the principal of your mortgage and have time to build your reserves.
Thinking long-term about your rental means you’ll fare better when you face a costly eviction or major repairs.
8. Pay attention to the legalities
Each state has its own laws surrounding property owners and tenants, and you can save yourself some hassle by researching those before you buy a rental property. Here are several laws you’ll want to become familiar with:
- Laws about discrimination when you screen tenants
- Lease agreements
- Required disclosures
- Laws about providing a safe environment, including infestations
- Landlord responsibilities about making repairs
- Security deposits
- Renters right to privacy
- Abandoned tenant property
- Laws about criminal activity
- Regulations regarding the eviction process
Understanding these laws now is taking a proactive step that can save you money (and a lot of legal hassle) in the future.
9. Consider a property management company
Hiring a property manager turns your rental property into a much more passive investment. They take care of finding renters, running background checks, collecting rents; and managing cleaning, repairs, and routine maintenance. The point is, they can save you a ton of time.
But that time saved costs money, and you can expect residential property management to cost between 8-12% of the monthly rental value of the property, plus expenses.
Property owners are divided on this with about half of rental properties being managed by the property owner themself, according to a study done by TransUnion. However, the same study found that the more properties owned, the more likely the owner hires a property manager.
10. Calculate your ROI
ROI, or return on investment, is a way to understand the value of your investment. Real estate experts suggest that individual investors shoot for a return of 10%.
Here’s how you calculate your ROI:
- Estimate annual rental income: You can estimate this by researching what similar rental properties in the area rent for each month.
- Estimate annual expenses: You’ll want to add up taxes, insurance, maintenance, repairs, mortgage, cost of the property manager, and HOA fees.
- Figure your net operating income: Subtract your annual rental income from your annual expenses.
- Determine your total cash investment: This is the total upfront cost you’ve incurred, including down payment, closing cost, repairs, renovations, etc.
- Divide your net operating income by your total cash investment.
Keep this formula in mind when you’re looking at properties because it can make one look like a much better investment than another.
The final word: Is buying a rental property right for you?
Rental property can be a solid investment if you’re prepared. Not everyone will be at a point in their life when owning rental property makes sense. You need to be realistic about the costs, your ability to manage a rental, and how that will fit in with the rest of your finances.
Buying a rental property shouldn’t be something you enter into lightly, no matter how promising the investment looks. Take your time, do your research, and be ready to put in the hustle that will turn your first rental into a solid investment.