Adam Luehrs is a writer during the day and a voracious reader at night. He focuses mostly on finance writing and has a passion for real estate, credit card deals, and investing.
The main reason to invest in a rental property is the potential for financial freedom. When you own a desirable rental property, you get security, peace of mind, and a sense of control over your future. However, many people never dive far enough into the process to actually obtain the freedom they want.
This guide for novice investors covers key steps, tips, and potential pitfalls to look out for that will help you reach your goals in this exciting investment journey. Read on to take the first leap and to understand the basics of how to properly invest in a rental property.
The pros and cons of owning a rental property
There are many advantages to owning a rental property. The most obvious one is that you make passive rental income every single month. What’s more, you’ll be reaping the rewards of your investment long after you’ve paid off your mortgage. The property you buy and invest in today could be your retirement gem. Here’s a quick rundown of just how sweet the perks can get:
- Steady cash flow once you have regular tenants
- The ability to invest your return on investment (ROI) in new properties to make even more money
- A reputation as a leader in your community
- The ability to pass on a money-making asset to your children
- The ability to “work” from anywhere
- Greater predictability than putting money in stocks or potentially volatile investments
- Control over your own business
- Tax benefits and deductions related to owning and managing an investment property
- Protection against inflation
- The benefit of capital growth as your property increases in value over the years
It’s also important to be realistic about the fact that owning an investment property isn’t always smooth sailing. It takes a fair bit of work and patience to become a real estate investor and landlord. Let’s take a look at some of the cons we need to be realistic about before hopping on an investment opportunity:
- Entry costs can seem overwhelming once you crunch the numbers
- There will be exit costs if you decide to sell a property down the road
- You may need to cover costs if you go for stretches of time without tenants
- Things like repairs and taxes could have you pulling funds out of your own pocket during the first months of owning a property
- You will need to do short-term repairs and long-term maintenance on a property for as long as you own it
- You will have to handle the task of screening tenants every time there is turnover
Don’t be overwhelmed! Many landlords actually find that most of their fears fade away once they begin the process of investing in rental properties. Having all the knowledge you need going in can help you to avoid feeling like you’re making mistakes or missing obvious signs.
How to get started with buying a house to rent
It can seem like there are more questions than answers when you first sit down to create a strategy for scooping up a property. It isn’t as simple as checking out the listings in your area to see what’s affordable. You may need to get creative when it comes to finding a property in your price range.
Here’s a quick cheat sheet for what your journey into the rental market can look like:
- Set a maximum budget for a total investment that takes into account repairs, closing costs, taxes, and more
- Narrow down your search to specific neighborhoods
- Compare home sales and rental rates to determine which neighborhoods offer the best return on your investment (ROI)
- Try to catch off-the-radar properties by driving around to spot neglected homes or mailing invitations to sell to residents
- Decide how much repair work you should do on your own versus hire out to contractors
- Have a home inspection before making any offers
- Secure financing
You may think that simply looking for the home with the lowest purchase price is the key to securing your bottom line. However, price isn’t everything. You should actually be focused on how the numbers work out once you factor the money in versus the monthly rental income you can generate.
A home costing $200,000 that can generate $2,000 in income each month without the need for any repairs can easily be a better deal than a home costing $150,000 that can only bring in $1,300 with the need for several costly repairs. The chasm can grow even wider if you’ll need to pay interest on money borrowed to make costly repairs.
The first thing you’re going to need to figure out is your net operating income (NOI). You can do this by simply subtracting your anticipated operating expenses from your anticipated real estate revenue.
The next step to vetting a potential property is measuring your cap rate. A cap rate equals your annual net operating income divided by your acquisition price. Just multiply whatever number you get by 100 to turn it into a percentage. It’s obvious that higher percentages are better when it comes to the cash flow you’re going to see on the property you purchase.
Let’s talk about how to calculate rental income for a moment. There is one very basic rule to follow when weighing how much you need to charge against how much you’ve paid in total, which is referred to as the “1% rule”. Here’s the simplest breakdown to remember:
- A property with an acquisition cost of $100,000 should rent for at least
- $1,000 per month
- A property with an acquisition cost of $200,000 should rent for at least
- $2,000 per month
- A property with an acquisition cost of $300,000 should rent for at least
- $3,000 per month
You can pretty much follow the numbers as you get into the luxury-property range. You can also add about $500 for every extra $50,000 you spend on a property. Of course, there are many different factors that could make it possible for you to charge much more. This breakdown is simply showing the very minimum you could charge to get in the range of being profitable. Make sure you’re including things like closing fees, loan interest rates, and repairs in your total acquisition cost.
How home categories impact your rental potential
Different types of investments can impact how much you’re able to collect in rent payments. One of the simplest ways to generate rental income is to obtain a single-family home that a tenant can use as a primary residence. You will be able to put a cap on the number of people who may live in the home at one time.
Going with a single-family home can also be a good way to attract families looking for secure, affordable neighborhoods near schools and workplaces. Of course, the big downside to renting out a single-family property is that you’re only collecting one rent check from your investment every month.
Some landlords prefer to deal with multi-unit homes and condominiums because they offer potential for several streams of rental income and limit the downside if a tenant moves out and a unit is vacant. Of course, dealing with multiple tenants means spending more time managing your property.
In addition, you will need to potentially pay for repairs more frequently and screen tenants more regularly. Buying a multi-unit home or condominium will almost always cost slightly more in dollars and mental energy than simply purchasing a single-family home in the same neighborhood. The payoff is often there for you if you’re willing to put in the extra work that is required to handle rental properties with multiple dwellings.
How neighborhoods influence your rental potential
Selecting a neighborhood to focus your search efforts on could be the most important step you take on your way to becoming a landlord. Did you know that neighborhoods are actually broken down into three classes by property investors searching for homes? Here’s a look at how it works:
Class A refers to highly safe neighborhoods that attract low turnover, low vacancy rates, and high-quality tenants. Homes located in this type of neighborhood tend to be larger. They also tend to offer features like garages, central air, swimming pools, and more.
Class B refers to neighborhoods that attract mild turnover, mild vacancy rates, and mid-quality tenants. Homes here may be in need of style updates and general upgrades. You will typically be purchasing homes from people who have lived in them for 30 or 40 years.
Class C refers to neighborhoods that attract high turnover, high vacancy rates, and high crime. You are often looking at a full rehab project when you invest in rental properties in one of these neighborhoods. That can cover things like a new roof, new windows, plumbing updates, and electrical work.
The amount that you can charge in rent is obviously impacted by the class of neighborhood you choose. In addition, overhead costs could be higher in places where turnover and vacancy rates are high. That means you’re potentially getting hit in the wallet on two fronts when investing in Class C.
However, the nice thing about considering Class C is that you may come out with what essentially works out to be a new home once all of the renovations are done. Getting all of the needed repairs out of the way means you might not have to invest in any more major work for at least 20 years.
Sourcing a rental property can also be a challenging task when you start to invest. Luckily there are many ways to find the right property once you have decided the home category, the neighborhood, and your price range.
Some options include:
- Working with a Realtor to help your source as they have access to MLS listings
- Looking at data from courthouses, websites, foreclosure lists, even obituaries for probate leads
- Setting up a marketing campaign like direct mail, Facebook ads, or other resources to find motivated sellers
- Network in the real estate investment community; go to events, join social media groups, and find connections
- Go to auctions
- Drive around neighborhoods and spot potential leads to target
Things to be aware of before buying
Having stars in your eyes could block you from seeing the bottom line if you’re interested in learning how to make money with rental properties. What do most landlords wish they knew before purchasing rental property investments? Take a look at some potential reality checks to keep in mind.
Tenants won’t always treat your property well
Never underestimate just how much damage a tenant can do! Ruined carpets, missing doors, smashed-in walls, and broken floor tiles can all shock you when doing an inspection after a renter moves out.
However, it can be even scarier to realize that renters were unaware of serious issues like slow leaks, damaged pipes, or precarious electrical setups that went ignored or unreported for far too long. Some renters will even make unapproved upgrades that are done outside of compliance with local code. Don’t forget about damage from pets you didn’t even know about! Just be sure to have a robust renter’s agreement to prevent any future headaches.
Repairs can come out of nowhere
A rental home is just like your primary residence when it comes to maintenance. Everything is essentially on a timer when it comes to breaking down. There’s a good chance that you will eventually have to replace a furnace, stove, roof, or driveway. The good news is that you can stay one step ahead of repairs by keeping a robust repair fund growing each month when you collect rental checks that act as a reserve for a rainy day.
You have no control over property taxes
A town’s tax rate is a wildcard that can really eat into profits over time. You may get excited to see that your rental home is appreciating in value. However, your town tax collector may also notice that when the time comes to do an assessment. The bad news about the good news of having a property that’s increasing in value is that your property tax is almost guaranteed to go up. In addition, towns can vote to raise taxes without warning if costs related to road repairs and education need to be covered.
Start the journey
How do you turn your dream of investing in rental properties into a reality? The truth is that you won’t get very far without financing. Make sure you set aside some time to check out flexible options like bridge loans while you’re busy scoping out neighborhoods and comparing the different types of investments that are knocking at your door. LendingHome offers flexible, quick financing options that make investing in rental properties feel natural. With low rates, high leverage, and flexible property income requirements, you are in good hands!
Disclaimer: The above is provided for informational purposes only and should not be considered tax, savings, financial, or legal advice. All information shown here is for illustrative purpose only. All views and opinions expressed in this post belong to the author. NMLS ID: 1125207 Terms, Privacy & Disclosures. Copyright LendingHome Corporation 2019.