Forty-three million U.S. households are renters. If you’re thinking about buying a rental property, that number might mislead you to believe it’s an easy way to make a buck. Real estate investing can be an excellent passive income stream, but success requires due diligence. I’m going to walk you through the steps of buying your first rental property, so you don’t lose money – or your sanity. Let’s dive in.
Buying rental property is a long-term investment, and you want it to be profitable. You’re putting a lot of money towards a downpayment. You need to arm yourself with all the information you can.
What to Know about Buying Rental Property
Determine what the eviction laws are before committing yourself (and money) to a particular area. Of course, you don’t want to evict a tenant, but if someone is living in your place and not paying rent for months, that’s unacceptable.
How long does it take to evict someone? In places like New Jersey, it can take months to remove someone while you wait around losing money.
How easy is it to raise the rent? There could be rent stabilization laws in place that don’t allow you to raise rents as you see fit.
How likely is it that you can use their security deposit for damages?
Getting answers to all of these questions is crucial. Start by looking for places that are landlord-friendly states.
The top 9 landlord-friendly states:
Positioned Near a Thriving Neighborhood
Consider if your potential rental property is located in a bustling, up and coming neighborhood or college town. It’s also important to note available jobs and how large the tenant pool is.
If there are jobs (or job growth), then that increases the odds of people wanting to live there. Do the homes in the area appreciate?
Some areas are next to amenities like malls, offices, and retail parks, which enhance a rental’s value.
Real estate markets vary by location, and that’s why you want to consider these factors before making your purchase.
General Property Grade
Location is critical in buying an investment property. Each one you look at will have a grade, A through D. This will help you determine if the property makes for a great investment.
Buying an investment-grade property is about focusing on the critical criteria that will keep your property occupied and stress-free. Here is the breakdown of the ratings.
High-quality buildings built within the last 15 years. They may include premium amenities for attracting high-income families, require a larger downpayment, but with lower returns.
Slightly older property, but still nice. The area won’t be quite as lovely, however, as the A-properties. These properties tend to have middle-class tenants.
Rental income is typically lower than the A grouping and may have minor maintenance issues. Usually, these properties are in good condition and live-in ready.
Tip: Look for B-grade properties in middle-class neighborhoods to invest in.
Older properties more than 20 years old and located in less-than-desirable neighborhoods. They could also use some work. However, for real estate investors, these rentals have high returns when flipped and sold for a profit.
These are rundown properties in bad areas. The neighborhood and property can be described separately.
For example, it’s possible to have a run-down property in an excellent area. But it’s much more challenging to have a great property in an unfavorable area.
An investor needs to understand it’s vital that each class of property comes with varying levels of risk and reward.
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Rental Property Types
Typically, most investors get started with a single-family rental. There are fewer upfront costs, a high-quality tenant pool, and higher demand. They’re also easier to sell. Why?
Because both families and investors are buyers.
Financing a single-family home is more straightforward, it carries lower interest rates (potentially lowering monthly mortgage payments), and lacks the complexity that comes with larger properties.
This real estate investment lets you rapidly increase your real estate portfolio. If you mortgage seven triplexes that yields 21 units compared to seven single-family homes.
There is also the potential to make one of the units your primary residence while renting the others out.
Not only does this provide you with ‘boots on the ground’ style of looking after your units (if being a landlord is important to you), but gains you access to particular loans.
For example (when using the investment property as your primary residence), to qualify for an FHA loan, you’d need a FICO score between 500-579 to gain access to only paying 10% down. If your credit score is 580 or higher, you’d only need to pay 3.5% down.
That’s a colossal difference from putting down 20% with a conventional loan. Check with lenders in the area to see your loan eligibility.
Turnkey Rental Properties
If you’re looking for something that’s move-in ready and can potentially generate immediate positive cash flow, a turnkey property might make sense.
You no longer need to live in the same area as your rental property. If your city has a high cost of living (e.g., New Jersey), consider investing where the prices are lower.
You no longer need to live in the same neighborhood as your rental property.Tweet This
Andrew and I have one rental property in Indianapolis and two in Georgia. You’ll pay a higher cost since you’re paying a management company to run the daily operations, but you’re still the property owner.
What’s a Good Purchase Price?
When buying rental property (single-family homes), we typically look at properties between $80,000 – $150,000. If we abide by the 1% Rule, rent falls between $800 – $1,500 a month.
The 1% Rule says your monthly rent should be equal to or greater than one percent of your home’s purchase price.
One percent of $150,000 equals $1,500 in monthly rent.
Property Taxes, Crime, and Schools
It’s a great idea to calculate what you’ll pay in annual property taxes for your rental. The number varies, which is why it’s better to know beforehand.
Google ‘taxes by county’ and ‘by state’ to determine what’s good. The national average sits slightly above 1%. Aim to pay between 1% and 2% annually.
Googling crime rates in the area and median income by neighborhood are excellent ways to determine potential property value and whether it’ll make for a sound real estate investment.
Understanding Vacancy Rates and Potential Renters
When buying a rental property, vacancy is inevitable. The vacancy rate is the percentage of all available units in a particular area that is unoccupied at a given time.
Look at the US Census data on vacancy rates in the area you’re seeking to purchase. With two minutes of research, you’ll have a pretty good idea of what this number is. Plug that number into our rental evaluator.
Get as much research on the tenant as possible. Often your management company will do this for you in the form of credit reports and their financial history.
If you’re Googling someone you’re going on a date with, you’ll do the same for potential renters.
If the person wanted privacy, they should have set it as such in their social media accounts. Use any available information to help you make the right decision.
When looking at potential properties, you may come across something called Section 8. It provides the tenant affordable housing support from the local housing authority. The federally funded Section 8 housing voucher is intended to disperse poverty.
- Regular, timely checks from the government.
- Easy marketing (there is a significant demand for landlords that rent to section 8 tenants).
- Usually, the rents are higher than the market average.
- Little recourse for damages. You have to appeal to the section 8 office.
- Guesthouse: Be mindful of guests offering space to additional family members not originally on the lease.
- The section 8 office can change the rent on you (+/- $50ish) and even change the proportion of the rent paid by your tenant with little to no notice. It could modify the viability of the deal.
Repairs and Older Construction
It’s not a matter of if things will break, but when. Roofstock provides an insanely detailed document on this, and you can inquire deeper if you have concerns.
Roofstock wants to remove all unknowns from the transaction; it’s not their property, and they want the deal to be a good one.
Look for properties that aren’t going to need a roof in under four years.
You shouldn’t spend more than $1,500 on renovations and avoid properties with significant structural concerns.
Protect Yourself Against Unanticipated Expenses
You want to prepare for the worst, so no one thing can ruin your investment. What sort of natural disasters could occur in your area (if any)?
Global warming is a real thing. Do you live in an area prone to flooding or tornadoes? Imagine what could happen and plan for it.
Get the proper insurance for the edge cases. You want to keep your insurance costs low by using a high deductible. You’re never going to make a claim unless you need it. Otherwise, your premiums will rise.
Tip: Set aside a portion of your income to cover the deductible in a worst-case scenario.
So, get covered for the big disasters and plan for the small ones with your reserve account. Making insurance claims for minor fixes could increase your monthly bill for years.
Over time that $500 window fix could end up costing you a lot more.
Shop around for the best deal. Most insurance quotes are just an arbitrary number. Companies vary dramatically for the same coverage.
Ask to know what you are paying for.
Build a Strong Team
Property Management Company
You won’t get white-glove service – it doesn’t exist. Simply look at how much they get paid.
However, you can find people with strong communication skills and an online system to track costs that will keep the stress off your back. Some questions to ask potential management companies are:
- What are the terms of the agreement?
- How much do they charge you to find a tenant or resign a lease?
- When work is necessary, will they run point and handle it for you? How much extra do they charge for that?
When it comes to management fees, 10% is pretty standard. If there is any way to reduce the charge, take it. Negotiate lease signing fees. If you act like a big fish, they will treat you like one.
ExcaliburHomes in Atlanta GA started us at 8%, a fee pre-negotiated by Roofstock.
However, we saved 1% by getting paid on the 23rd of the month instead of the 9th. I kept an additional 1% by getting my statements online. It increased the cash-on-cash return by 2.25%!
There are many moving parts when buying rental property. Following the advice in this post will save you from potential headaches or worse – losing money to things you didn’t know you didn’t know.