Thinking of buying your first rental property? You’ll be in good company: 90% of millionaires made their money in real estate, and you can, too.
But before you dive in, you ought to know a thing or two about what it takes to be a landlord and how to choose an investment property.
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Know your end goal
Why exactly do you want to purchase a rental? Is it to boost your retirement income when you get old, to diversify against your stock market investments, or to provide immediate cash flow?
These are essential questions to answer before you start investing in real estate because they will help guide you as you go along. Start with a clear goal in mind and let it shape how you move forward.
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Determine if you want to be a landlord
Being a landlord isn’t for everyone. Even though rental property is sometimes referred to as a passive investment, it can be a lot of work. Rentals require dealing with unexpected repairs, routine maintenance, and finding, screening, and managing tenants.
But don’t let this scare you away. If you aren’t up for the job, you can always contract it out to various vendors (e.g., cleaners, repairmen, marketers, etc.) or hire a reputable property manager to take care of everything.
Most property managers charge between 8% to 12% of the monthly rent collected. In exchange, they take care of property maintenance, marketing, tenant management, and more.
When you consider all the time and effort they’ll save you, a property manager could be well worth the cost.
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Decide how to finance the rental property
When it comes to the purchase of a rental property, you have two primary options: You can either buy it outright with cash or finance it with a mortgage. Each has pros and cons.
Buying in cash is more secure because it doesn’t require taking on debt. Most first-time investors don’t have that kind of money, though, and even if they do, buying is not always in their best financial interest because it entails significant opportunity costs.
Let me explain. Say you want to buy a $500,000 rental property and you have enough money to buy it outright. Buying with cash may give you some peace of mind, but it also means giving up a lot of capital.
If, however, you were to finance the same property by putting down only $100,000 (20%), you’d still have $400,000 left over to invest elsewhere. You could use that money to buy a second investment property.
The vital issue is whether the returns you’d make from investing the extra cash are more than the interest you’d pay on the mortgage. In most cases, it is.
Plus, you can write off mortgage interest on your tax return. Do the math to see whether buying in cash will be worth it.
By financing your rental property, you can also take advantage of leverage. Even though you may be putting down only a fraction of the property’s cost, you still get to reap 100% of the returns. Check the current average U.S. mortgage rates and run the numbers to see which financing strategy yields the better return on investment (ROI).
Keep in mind that if you choose to take out a mortgage, you’ll still have to make a down payment, which is typically around 20% of the loan. However, if you plan to live in one of the property’s units (i.e., house hack), you may be able to get a mortgage for a much lower down payment.
For example, FHA loans let you put down as little as 3.5% on properties with up to four units (though you’ll also be required to get private mortgage insurance).
You’ll also have to get prequalified for a mortgage. To do this, most lenders require a credit score of at least 680, proof of stable income (usually two years’ worth), a low debt-to-income (DTI) ratio (no higher than 43%), and an emergency cash reserve.
However you decide to finance your rental property, you’ll need to start saving up money and firming up your finances right away.
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Choose a rental strategy
As a property owner, you can choose from two main rental strategies: long-term and short-term. Long-term rentals are designed for housing tenants on a 12-month lease that can be renewed each year. They provide the most predictable monthly income because tenants don’t change that often.
In contrast, short-term rentals (STRs) are designed for guests who stay only a few days at a time. You can list your STR on platforms like Airbnb and VRBO and let your users book your STR in advance. Since occupancy rates aren’t as predictable, your monthly income won’t be, either.
Both strategies can provide great returns. The right one for you will depend on your preferences.
For example, STRs require considerably more maintenance and cleaning between guests. But they may also bring in more total rental income, depending on the location– which brings us to our next point.
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Choose the right location
Before you purchase a rental property, it’s crucial to research the rental market in the area you are looking in. Your research may involve looking at the area’s job growth, population growth, school districts, amenities, crime rates, number of competitive rentals, average income per household, family demographics, and property tax rates.
All of these play a factor in how good a rental property investment will be. So you should perform appropriate due diligence.
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Estimate your investment returns
Once you’ve chosen a rental market, you’ll want to analyze individual property deals to see what kind of returns you can expect. You can make money from rental properties in two main ways: appreciation and cash flow.
Appreciation refers to how much the property rises in value over time. For example, if you buy a property for $100,000, it goes up in value, and you sell it a year later for $110,000, that’s a return of 10% ($110,000 ÷ $100,000).
Cash flow refers to how much is left over from your rental income after all your property and operating expenses are paid. If the property rents for $1,000 a month, and your monthly property and operating expenses total $900, your monthly cash flow would be $100.
In many cases, cash flow and appreciation are inversely related. Some rental investments may offer good appreciation without much cash flow and vice versa. Calculate both metrics and choose a property that matches your goals.
To do this, you’ll need to list out your expected rental income and rate of appreciation along with all your expected property and operating expenses: the monthly mortgage, property taxes, home insurance, property management, and so on.
Budget for unexpected costs, too. These could include unexpected vacancies, evictions, large repairs, and more. A good rule of thumb is to save about 20% to 30% of your rental income for property maintenance. That way, when the unexpected happens, you should have enough to cover it.
Also, don’t forget to factor in rental property tax write-offs. At the end of the year, you can deduct mortgage interest, home insurance, maintenance, repairs, and even depreciation.
If you ever sell the property, you can defer capital gains taxes with a 1031 exchange. In short, real estate investors get a lot of tax breaks you should take advantage of and account for in your return estimates.
Need help doing the math? Use a free online rental property calculator. It lets you plug in all the numbers and then computes them for you.
Ideally, your rental property should pass the 1% rule, which says your monthly rent should equal 1% of the purchase price (plus any needed repairs). If it doesn’t, you probably ought to keep looking.
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Understand landlord laws
When you become a landlord, you must respect various housing laws and regulations. For example, zoning restrictions may limit how many occupants you can have in your rental property based on its size.
Landlord-tenant laws may regulate how you handle security deposits, evictions, and tenant screenings. And the Fair Housing Act prohibits discrimination against rental applicants based on race, color, national origin, religion, sex (including gender identity and sexual orientation), familial status, and disability.
Learn your obligations as a landlord so you don’t inadvertently run into legal trouble.
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Get a home inspection and appraisal
Before you sign on the dotted line, make sure you get a professional home inspection and a home appraisal.
A home inspection assesses a property’s condition. This includes the condition of the structure itself, the roof, the heating and cooling systems, the plumbing, the electrical work, the water and sewage systems, and more.
A home inspector can alert you to potential issues with the property (e.g., red flags and necessary repairs). That way, you’ll know what you’re getting into.
A home appraisal is a professional and objective opinion of a home’s value. Most lenders require you to get one before they’ll grant you a mortgage because they want to know what the property is actually worth.
But as an investor, it’s a good idea for you to confirm the home’s value anyway so you can make accurate investment calculations. In the long run, both a home inspection and a home appraisal can save you plenty of headaches, so they are well worth the cost.
Final thoughts
Follow these tips when choosing your first rental property and you’re more likely to make a good investment.
It may take a lot of work upfront, but it could be the start of a lucrative real estate investing career. Be thorough in your research and you’ll be just fine!
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