Investing in your first rental property can seem like an exciting but daunting process. While residential rental properties can be a very rewarding investment, there can also be a lot of risks involved. To help you feel confident when investing in rental properties, it’s important to equip yourself with the right knowledge and tools to help you check off the steps to mitigate potential risks.
Some of the factors you will want to consider include:
- The property’s condition
- The property’s location
- Financing needs and options
- Financial resources & guidelines
- Another Option For Successful Rental Property Strategy
This guide to investing in a rental property will clue you into some of those key insights. This will help you avoid unnecessary hassles and common missteps, minimize risk, and maximize your returns as you embark on your residential rental investment journey!
Rental Property Condition
Rental property condition has a major effect on property value appreciation, which directly affects the short-term return and long-term potential return from your investments.
Having a good understanding of the property’s condition before buying is crucial. Here are the key components you need to know before making an investment:
Fixer-uppers aren’t ideal for beginner rental property investors
Finding a building with “good bones” (but in need of some surgery) for a low price tag may seem like a great opportunity, but keep in mind that renovation projects require their own set of skills to manage, as well as both expected and unexpected time and money to see the project through.
Surprises that are not initially visible are common, as layers of old construction are removed, overrunning cost and timeline. Since units under construction can’t be rented out until the work is complete, this results in negative cash flow right out of the gate.
It is recommended that beginner investors who intend to focus on rental property avoid taking on this level of risk, uncertainty, and complication for their first investment. Instead, focus on properties that are ready to rent or those that come with already existing stable tenants.
Once you have some real estate investment experience under your belt and a network of contractors you trust, you can consider taking on a more complex project that requires some initial renovations. You’ll be more knowledgeable about the features renters are looking for, what kind of time and cost investment that may be required, who your target renter should be, etc.
Befriend your property inspector
Property inspection is a crucial part of the purchase process and if you’re relying on a mortgage to buy, the bank will require this before closing the sale.
Instead of leaving everything up to the property inspector, you should be more involved in assessing and understanding the condition of any rental property you might purchase beyond simply awaiting an okay from a property inspector or skimming through their report.
After all, if you decide to purchase the property, maintaining and improving the condition of the rental property will fall on your shoulders and your ability to do so will impact the property’s future value and your rental income. Equipping yourself with all the knowledge you can get about your property will help you maximize the condition of the property, which will influence the rent you can charge, as well as the vacancy rate.
A standard building inspection will describe the state of these building features:
- Other structural components
- Insulation (though generally only what is visible)
- Major systems: heating, cooling, indoor plumbing and electrical
- Walls, floors, ceilings, doors & windows
Find out if you can accompany the building inspector as they walk through the property. Tell the inspector how much you appreciate their work and try to establish a friendly line of communication.
Accompanying the inspector will give you a chance to see potential issues up close, and ask a few questions to ensure you understand the implications. (“Yes, I see the damage you’re referring to there – how much does something like that usually cost to fix? How soon do you think that needs attention? What will happen if I wait to address it?”)
There are lots of other advantages to accompanying the inspector. As a professional who spends lots of time looking at different units and buildings, they will likely notice many aspects of a unit beyond what will make it into their official report – things that may be outside the report’s scope but still very helpful for you to know. Get them chatting during the walk-through and you’re likely to get alerted to other maintenance items needing attention.
At the end of the building inspection, ask the inspector to level with you: What is their personal opinion of this property? The property inspector likely has that bird’s eye view, a useful comparative take on this property from someone with an informed perspective. Accessing that, if possible, can be very helpful in your decision-making process, allowing you to have a comprehensive understanding of your property and its needs.
Gather as many informed opinions as you can
If you are especially concerned about a certain aspect of the building, like the roof or the plumbing, it may be worthwhile to have a specialized contractor assess that element separately.
Contractors generally have an interest in identifying problems so they can offer their services to do the repairs, so it’s best if you have established relationships with contractors you can trust for this purpose. If not, ask for recommendations from other nearby property owners, property managers, and local hardware stores (they often keep referral lists).
Word of mouth and reputation are incredibly important in the realm of contractors and home repair professionals. Find out all you can through the grapevine about who’s trustworthy and who to avoid.
Additionally, if you are able to have a contractor prepare an estimate of repairs they believe are needed before purchasing the rental property, you may be able to use that in the sale negotiation.
Other Key Property Characteristics
There are some other essential property characteristics to consider before you purchase a first rental property. Here are some insider tips:
Small, single-family homes are usually recommended for beginners investing in rental properties. The complexity, risk, and workload is generally lower and will allow you to get your feet wet investing in real estate and handling rental property to grow your knowledge, skills, and contacts. Later, you can expand your rental property portfolio with more confidence.
Keep a professional perspective as you shop
Unless you’re considering buying a duplex or other multi-family real estate that you plan to live in yourself for a long time, you should keep your personal preferences out of your decision-making as much as possible. At the end of the day, it is an investment, not your dream home.
This can be challenging with residential real estate. Everyone has strong feelings associated with their experience, ideas, and preferences. For most of us, that emotion can easily get entangled with our assessment of a residential property as a potential investment.
It’s wise to be aware of these feelings and how they might be influencing your judgment during the shopping process. You want to invest in a property that potential renters will find appealing to call home and that could mean that the property doesn’t appeal to your specific sense of an ideal home. Don’t pass up a great investment property because of your own biases about what kind of home you prefer when that’s not likely to be relevant.
Location Key Factors
Local market knowledge is crucial to making a wise rental property investment. Here are the key factors to consider:
What is your strategy for gathering local insights?
The longtime wisdom in rental property investing is to invest where you know, ideally close to where you live. This makes it more likely you have a built-in sense of market conditions while facilitating maintenance calls (assuming you plan to manage your rental property yourself).
However, it’s becoming easier to invest in rental property farther afield, with online tools and marketplaces that facilitate this. Additionally, it’s likely that your best investment opportunity isn’t in your own backyard. That being said, If you invest far from where you live, you will need to gain local market insights and assistance from others – i.e., a trusted local real estate agent, a great property management company, and other locals with good insight into the residential rental property market.
Consider location at the neighborhood, city, and regional level
You should know the relevant economic and demographic trends for the overall region, municipality, and neighborhood. Is the region adding jobs and population? What about in specific pockets? What big civic infrastructure is planned or being built? What transportation, entertainment, parks, and other amenities are available? What kind of development is underway?
Get to know the neighborhood through research, networking, and by simply spending time there at different times of the day and different days of the week.
Get the data: vacancy rates, average rents, etc.
Learn as much as you can about market conditions through hard data like average rents in the area, vacancy rates, etc.
Your Financing Needs & Options
If you don’t plan to buy your first investment property in cash, you’ll need to obtain financing. Here are some key items to consider before you finance your first rental property investment:
Lenders usually require a larger down payment for a property you don’t plan to live in
Twenty percent is standard and if you have the cash, it’s smart to use it. It will lower your interest rate, monthly payments, and the overall cost of borrowing.
However, for those who don’t have twenty percent of the purchase price on hand as a down payment on investment property, there are workarounds.
Many beginner rental property investors take advantage of owner-occupied financing
Down payment requirements are generally much lower for the properties you plan to occupy. FHA-backed (U.S. Federal Housing Administration) financing allows for down payments as low as 3.5 percent of the purchase price.
That includes multifamily properties, where you can live in one unit and plan to rent the others. This is a great way to gain a foothold as a rental property investor without having to save up for a 20 percent down payment.
Whether you opt for single-family or multi-family real estate, one year of occupancy is standard in mortgage terms, so after a year you can convert the property into a rental and keep the original financing.
This is a general guideline, but be sure to check any specific mortgage terms before closing a deal.
Financial Guidelines & Resources to Ensure Success
You will more than likely need more cash on hand than just the down payment to start investing in rental properties and will need to know what to expect in terms of operating expenses and cash flow. Here are some rough guidelines for your success:
The 50% rule
This rule offers a quick-and-dirty guideline for what operating expenses are likely to be on a single-family home. According to the fifty percent rule, operating expenses will be about half the gross rents. That means the other half can go toward a mortgage on the property or profit.
The 1% rule
This investment rule for rental properties holds that the gross monthly rent should be at least one percent of a property’s price tag. This means that a property will take 100 months to pay for itself.
If you buy a property in need of some urgent, expensive repairs, it’s a good idea to add the cost of those repairs to the purchase price for purposes of analysis using the one percent rule. Some investors prefer a 2% figure instead of one percent to maximize profit.
The other 1% rule
There is another 1% rule you might hear about in rental property investing. This one asserts that you should set aside one percent of a property’s value each year for maintenance costs.
Rules don’t give you a full picture!
While these high-level guidelines can be handy for running rough numbers, specifics really matter. Here are some other financial preparations to consider:
You should always have enough cash on hand to cover mortgage payments for at least a few months in case of unexpected vacancies.
You should put enough rental income aside each month so that you can cover known annual expenses, like property taxes and insurance.
You should put aside enough rental income each month to save for repairs needed over time due to regular wear and tear. Many components of your home have a defined lifespan – water heaters, appliances, the roof, etc. To get the most accurate savings target, estimate the cost for replacement and expected lifespan of major items and put aside a share of rental income every month to cover replacement costs.
You should keep an emergency reserve for unexpected damage and repairs. Buildings, especially older ones, are full of unpleasant surprises. Expect occasional major expenses to crop up suddenly – and be prepared to remedy them right away. Vacancies cost you money, so you can’t let damage be a barrier to turning over a rental unit. At the same time repairs can’t wait when it’s not you, but your tenants that will be impacted. Laws protect your tenants’ rights and happier tenants are likely to stay longer, reducing your vacancy rate and the cost and hassle of turning over a unit.
Another Option For Successful Rental Property Strategy
The hope of earning passive income is what makes rental real estate investing so alluring to many people. However, being a landlord can be time-consuming and demands a variety of different skill sets – often making your rental property investment a far cry from “passive” to manage at times.
Consider what it takes to service tenant needs in terms of handiness, schedule flexibility, and hours away from your other obligations and activities. Consider the work involved in marketing and showing a vacant rental unit. Consider what sort of demeanor you’re likely to show a tenant (i.e. your customer) when they call you at 2 AM about a plumbing disaster they may have inadvertently created.
How good are your people skills in that context? Do you have a strong network of contractor contacts to quickly and affordably resolve problems you can’t handle alone? How well do you know landlord-tenant laws and regulations at the municipal, county, state, and federal levels?
Many beginners in residential rental property investing with one or two rental units try to do this work themselves. This may or may not be possible or pleasant for you depending on your circumstances and availability. That being said, if you plan to grow your real estate portfolio, it’s likely you’ll want to look into a good property management partner to help smooth and streamline day-to-day management.
A property manager will handle many of the day-to-day chores of operating rental units in exchange for a small cut of your monthly rental income. Terms and quality of service vary widely among property managers, so it’s important to shop carefully for a partner you can trust with fair, affordable pricing. Beware especially of property managers who cash in on maintenance by charging per-visit or marking up costs on parts and labor.
A low-quality property manager will cost you a share of your profits and you’ll end up chasing them to get things done. A great property manager can pay for themselves by finding better-quality residents who stay longer and care for your property better. Remember – happier tenants result in lower turnover and fewer vacancies, with faster unit turnaround when vacancies do occur to reduce the impact on your rental income.
The Bottom Line
Investing in rental properties can be an effective way to increase your income. But getting out of a bad investment decision can be tough and potentially disastrous, so it’s better to understand common pitfalls and risks before you buy your first property.
The more you know about the property itself, its context in the local market, financing options, the likely operating expenses and cash flow, and what resources you’ll need to succeed in rental property investing, the more prepared you will be when you purchase your first rental property.
Gathering as much information as you can on the key factors mentioned above will go a long way toward making your rental property investment a success!