Tips for Buying Your First Rental Property

Are you considering buying an investment property? Many of the world’s wealthiest people have come from real estate, so there are plenty of reasons to believe it is a good investment. Experts agree, however, that before investing hundreds of thousands of dollars, it’s best to be well-versed in the field. Before you buy your first rental property, consider the following factors and challenges.

Important Points to Remember

Investing in rental property can be profitable, but it also has its drawbacks.
For a rental property mortgage, borrowers typically need to put down at least a 20% down payment.
From understanding basic tenant law to repairing a leaking faucet, being a landlord necessitates a diverse set of skills.
Experts advise having a financial cushion in case you don’t rent out the property or if the rental income falls short of the mortgage payment.

Determine if you have what it takes to be a landlord.

Being a landlord can be a lucrative way to make money in real estate, but it isn’t easy or glamorous. There are always maintenance hassles and headaches, in addition to choosing the right property, preparing the unit, and finding reliable tenants.

Do you know how to navigate a toolbox? How well do you repair drywall and unclog a toilet? You could hire a property manager or hire someone to do it for you, but that will eat into your profits. To save money, property owners with one or two homes frequently do their own repairs.

Being a landlord may not be right for you if you’re not the handy type and don’t have a lot of extra cash.

Personal Debt Reduction

Debt may be part of a savvy investor’s portfolio investment strategy, but the average person should avoid it. Purchasing a rental property may not be the best option right now if you have student loans, unpaid medical bills, or children who will be attending college soon.

Pereira agrees that caution is essential, saying, “If the return on your real estate is greater than the cost of debt, paying down debt isn’t necessary. This is the calculation you must perform.” Pereira advises keeping a cash reserve. “Don’t put yourself in a situation where you can’t pay your debts because you don’t have enough money. Always keep a safety margin in mind.”

Obtain a 20% (or greater) down payment.

Investment properties typically require a larger down payment and have more stringent approval requirements than owner-occupied properties. The 3% down payment you made on your current home will not work for an investment property. Because mortgage insurance is not available on rental properties, you’ll need at least a 20% down payment. However, you might be able to finance the down payment with bank financing, such as a personal loan.

Locate the Ideal Location

The last thing you want is to be stuck with a rental property in a declining neighborhood rather than one that is stable or growing. A city or location with a growing population and a revitalization plan in the works could be a good place to invest.

Look for a location with low property taxes, a good school district, and plenty of amenities like restaurants, coffee shops, shopping, trails, and parks when looking for a profitable rental property. Furthermore, a low-crime neighborhood with easy access to public transportation and a growing job market may attract a larger pool of renters.

Should you buy or take out a loan?

Is it better to pay cash for your investment property or to take out a loan? That is dependent on your investment objectives. Paying cash can help you have a positive cash flow month after month. Take, for example, a $100,000 rental property. With rental income, taxes, depreciation, and income tax, the cash buyer could earn $9,500 per year on a $100,000 investment, or a 9.5 percent annual return.

Financing, on the other hand, can yield a higher profit. For example, suppose an investor puts down 20% on a home and the mortgage compoundes at 4% per year. After operating expenses and additional interest are deducted, the earnings total $5,580 per year. The investor’s cash flow is lower, but the 27.9% annual return on the $20,000 investment is significantly higher than the 9.5 percent earned by the cash buyer.

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How to Get a Rental Property Mortgage

A rental property mortgage is similar to a primary residence mortgage in many ways, but there are a few key differences. For starters, rental property loans have higher default rates because borrowers who are having financial difficulties prioritize their primary residence’s mortgage. Because of the increased risk, lenders charge higher interest rates on rental properties.

Then there are the underwriting guidelines, which are usually more stringent in the case of rental properties. Lenders look at the borrower’s credit score, down payment, and debt-to-income ratio in general. The same factors apply to rental property mortgages, but the borrower will almost certainly be subjected to stricter credit score and DTI thresholds, as well as a higher minimum down payment. In addition, the lender may scrutinize the borrower’s employment history and income, as well as prior landlording experience.

In general, lenders require the following information from borrowers in order to approve a rental property mortgage:

A minimum credit score of 620 is required, with higher credit scores resulting in better rates and terms.
Down payment: Borrowers can put as little as 3% down on a conventional mortgage for a primary residence, but if the down payment is less than 20%, they must pay private mortgage insurance (PMI). Because PMI does not apply to rental property mortgages, borrowers must typically put down at least 15% to 20%.
DTI (debt-to-income ratio): DTI is the percentage of a borrower’s monthly income that is used to pay down debt. To qualify for a rental property mortgage, borrowers should have a DTI of 36 percent to 45 percent, though the limits are more flexible for primary residence mortgages.
Savings: Borrowers should have enough money in the bank to cover three to six months’ worth of mortgage payments, including principal, interest, taxes, and insurance, in addition to demonstrating a favorable debt-to-income ratio.

High Interest Rates Should Be Avoided

Although the cost of borrowing money may be low in 2021, the interest rate on an investment property is typically higher than that of a traditional mortgage. If you do decide to finance your purchase, you’ll need a low mortgage payment that won’t eat up too much of your monthly earnings.

Determine Your Margin

Because, among other things, they must pay staff, Wall Street firms that buy distressed properties aim for returns of 5% to 7%. Individuals should aim for a 10% return on investment. Annual maintenance costs should be estimated at 1% of the property value. Homeowners insurance, possible homeowners association fees, property taxes, monthly expenses such as pest control and landscaping, as well as regular maintenance expenses for repairs, are all costs to consider.

Purchase Landlord Insurance.

Protect your new purchase: Rental property owners should always purchase landlord insurance in addition to homeowners insurance. This type of insurance typically covers property damage, lost rental income, and liability protection in the event that a tenant or visitor is injured due to a lack of property maintenance.

Keep in mind that standard homeowner’s insurance may not cover losses incurred while the house is being rented out. Make sure you’re properly insured by contacting your insurance agent.

Investigate whether you can save money by bundling your landlord and homeowners insurance policies.

Consider Unforeseen Expenses

Maintenance and upkeep aren’t the only expenses that will eat into your rental income. There’s always the possibility of an emergency arising, such as roof damage from a hurricane or burst pipes destroying a kitchen floor. Plan to set aside 20% to 30% of your rental income for these types of expenses so that you have a fund to pay for repairs on time.

Fixer-Uppers should be avoided at all costs.

It’s tempting to look for a house that you can buy for a low price and turn into a rental. If this is your first property, however, this is probably not a good idea. You’d be paying too much to renovate unless you have a contractor who does good work for a low price—or you’re an expert at large-scale home improvements. Instead, look for a home that is undervalued and only requires minor repairs.

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Calculate your operating costs.

Your new property’s operating expenses will be between 35 and 80 percent of its gross operating income. If you charge $1,500 for rent and your operating expenses are $600 per month, your operating expenses are 40%. Use the 50 percent rule to make things even easier. Expect to pay $1,000 in total expenses if your rent is $2,000 per month.

Calculate Your Refund

What is your return on investment for every dollar you put in? Stocks may offer a cash-on-cash return of 7.5 percent, while bonds may pay 4.5 percent. A 6% return in your first year as a landlord is considered healthy, especially since it is expected to increase over time.

Purchase a Low-Cost House

The higher the price of your home, the higher your monthly expenses will be. Start with a $150,000 to $200,000 home in a desirable neighborhood, according to some experts. Furthermore, experts advise against buying the nicest house on the block—or the worst house on the block.

Is purchasing a condominium a wise investment?

Condos are a good option for rental property buyers because they are typically less expensive than comparable single-family homes and are frequently located in desirable areas (think: at the beach or a ski resort). Condos also have fewer maintenance requirements because the owners aren’t responsible for the grounds or the building’s exterior.

Financing a condo, however, is more difficult than financing a single-family home. Most lenders, for example, demand that at least 50% of the units be owner-occupied and that the homeowners association be in good standing. It’s also crucial to think about any potential special assessments. You may be able to pay the monthly dues without difficulty, but if the building requires a special one-time payment, such as a new roof, you may be responsible for thousands (or tens of thousands) of dollars.

Understand Your Legal Responsibilities

Landlord-tenant laws in their state and area should be familiar to rental owners. To avoid legal wranglings, it’s critical to understand your tenants’ rights and obligations regarding security deposits, lease requirements, eviction rules, fair housing, and other issues.

When is it appropriate to hire a property manager?

Owners of rental properties have the option of managing the property themselves or hiring a property manager. It can be a difficult decision to make because property managers typically charge between 8% and 12% of collected rents, which can significantly reduce profits.

Nonetheless, hiring a seasoned property manager may be well worth the investment. After all, taking advantage of their industry expertise means less work and fewer headaches for you. A property manager will, in general, do the following:

  • Understand how to market the house.
  • Understand the local rental market and make sure your rental is priced appropriately.
  • Show potential tenants the property (so you don’t have to)
  • Tenants should be screened (for example, conduct credit checks and verify references)
  • Rent is collected on your behalf and deposited into your bank account.
  • Take care of late rents and the eviction process.
  • Take care of tenant grievances
  • Make plans for maintenance and repairs.
  • Property-related bills, such as taxes, utilities, and insurance, must be paid.

Ask yourself the following questions to see if hiring a property manager makes financial sense for you:

  • Is it feasible for me to manage the property on my own? You won’t have the time or energy to manage a property on your own if you have another full-time job. This is especially true if you own several homes.
  • What is the distance between my home and the rental property? Being far away from the rental takes more time out of your day and makes managing routine and urgent issues more difficult.
  • Is it possible for me to deal with tenants? Even if you screen well, you’ll almost certainly have to deal with difficult tenants, late rents, and evictions at some point. Is that something you’d be interested in doing?
  • Is my rental property intended for short- or long-term renters? If you’re looking for long-term renters, it might be easier to self-manage. However, if it’s a short-term rental (such as an Airbnb), you’ll be dealing with a variety of tenants, as well as potential complaints and maintenance issues.
  • Do you feel the need to be in command? If you have trouble delegating tasks like tenant selection and maintenance, you might be better off managing the property yourself.
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Calculate the Benefits vs. the Risks.

Every financial decision must be made with the goal of determining whether the payoff is worth the potential risks. Do you think it’s a good idea to invest in real estate?

Rewards

You can earn money while putting the majority of your time and energy into your regular job because your income is passive, despite the initial investment and upkeep costs.

If the value of real estate rises, so will the value of your investment.

Real estate can be invested in a self-directed IRA (SDIRA).

Rental income is not counted as part of your taxable income for Social Security purposes.

You can deduct the interest you pay on a loan for an investment property.

Real estate values are generally more stable than stock market values, barring another crisis.

Real estate, unlike stocks and other financial products, is a tangible physical asset that you can see and touch.

Risks

Unless you use a property management company, tenants can be a pain to deal with, despite the fact that rental income is passive.

You may be subject to a 3.8 percent surtax on net investment income, including rental income, if your adjusted gross income (AGI) is more than $200,000 (single) or $250,000 (married filing jointly).

Your rental income may not be enough to cover your entire mortgage payment.

If the markets turn sour or you need cash, you won’t be able to sell real estate right away, unlike stocks.

The costs of entry and exit can be substantial.

Even if you don’t have a tenant, you must cover all costs.

Is It Necessary for Me to Find a Real Estate Investing Partner?

If you want to invest in a rental property but don’t have the funds (or expertise) to do so, a real estate partnership might be a good option. In layman’s terms, an investing partner contributes to the deal’s financing in exchange for a cut of the profits.

Keep in mind that forming a partnership isn’t a “easy button,” and it won’t relieve you of any responsibilities. You must still do your homework, practice your pitch, and be prepared to demonstrate to potential investors that the investment is profitable.

What Is the Best Way to Find a Real Estate Investing Partner?

To partner with a real estate investor, you don’t need a Wall Street connection. Instead, ask your own network of family and friends, join a local real estate investment club, look into real estate crowdfunding, or look for real estate-focused social media groups.

How Much Money Do You Need for a Down Payment on an Investment Property?

When it comes to rental properties, lenders usually have stricter guidelines. Although you can buy a primary residence with as little as 3% down, most borrowers will need to put down 15% to 20% on a rental property. Because borrowers in financial distress prioritize their primary residence’s mortgage, rental property mortgages have a higher default rate.

Should I Purchase a Condo?

Condos are frequently less expensive than comparable single-family homes, and they require less maintenance. However, financing a condo can be more difficult, as you must factor in ongoing association dues as well as the possibility of costly special assessments. When considering a condo as an investment, make sure to look into the homeowners association’s financial health as well as the overall condition of the building, not just the individual unit.

Final Thoughts

Keep your expectations in check. Rental property, like any other investment, will not produce a large monthly paycheck right away, and choosing the wrong property could be disastrous. Rental properties, on the other hand, can be a profitable way to invest in real estate. Consider partnering with an experienced partner for your first rental property. Alternatively, rent out your own home for a period of time to see if you have the potential to be a landlord.

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