Buying Your First Rental Property in 5 Steps
While the nuances of rental property investing are vast, the fact remains that planning early is critical. Investing in a rental asset involves an intricate and somewhat lengthy process, a fair amount of negotiation, and a ton of paperwork. Even so, there are quite a few phases of the process — and tips on the matter — that more or less apply to any prospective rental acquisition.
With that in mind, here are the five general stages involved in buying your first (or second, or third) rental property.
Investigating Options & Determining Goals
It may seem like hiring a good commercial real estate agent would be the best place to start, but you may want to hold off on that. Starting your search for a property on your own can offer significantly greater benefits. Agents get paid commissions and can pressure you into choosing a property or buying before actually securing an investment that suits your specific goals.
Besides avoiding unnecessary pressures right out of the gate, doing this research yourself helps to solidify any key characteristics for your target property — attributes like property type, location, size, and amenities. You should also consider whether the property will be actively managed by you or a property management company — which could significantly impact your geographic target area. After all, if you intend to take on the role of manager, the property must be reasonably close to where you live.
Only after sufficient searching and narrowing your focus do we recommend hiring a real estate agent to help you finalize a choice.
Gathering Information That Matters
There are plenty of official sources to scour for useful data points that relate to rental properties in any given market or MSA. Beyond that, you may want to make a few rounds talking to the locals and neighbors to get a more down-to-earth feel of the locale, where it is headed, and possible issues that may arise such as a raise in taxes.
Regardless of the function of the target property, it would behoove you to talk with renters as well as homeowners. Renters — having no true attachment or investment in the location — tend to speak much more honestly about any negative aspects of an area. Homeowners can provide useful insights as to the dealings of the local government and any major changes taking place in the area. Pro tip: If you really want to know the area well, make sure to pass through the area at different times and on different days of the week to get a clearer picture of the daily lives of the locals — particularly those in the immediate vicinity of your target property.
Making a Decision
There are many different types of rental properties with a host of different attributes and amenities to consider. Single-family residences are historically the best entry point for new investors of rental property. Condominiums are another relatively low-barrier entry point — condos typically have homeowners associations that do the lion’s share of taking care of things like external repairs and landscaping — leaving you to worry more about the simpler administrative tasks. The trade-off, however, is that condos typically have lower rents and appreciate more slowly than single-family homes.
Appreciation potential is often a driving factor in a rental property purchase. If your investigation and data gathering has at least narrowed the search down to a particular MSA or neighborhood, then your next move should be to look at the available properties with appreciation potential and an adequate projected cash flow for your goals. A good practice is to look both under and beyond your price range: Historically, real estate sells below listing price.
It goes without saying that it's highly recommended to buy a reasonably priced property to help ensure a return on your investment. The rule of thumb in the industry is to try to keep the acquisition price within 12 times the annual expected rental income. In regards to appreciation potential, the easiest and most common strategy is to find a property that can take a few, affordable cosmetic changes or minor renovations and command higher rents. Such improvements work doubly in your favor, as they also raise the value of the property.
Deciding on the Price of Rent
What you decide to ask for rent is completely up to you. That said, if you swing too wide in either direction it can, and often will, hurt your return. Assumptions can only go so far when setting a rent price. What you feel rent is worth and what tenants would be willing to pay could be two wildly different figures.
If you overprice the rent, you could have a huge vacancy issue on your hands, diminishing your profits. It is a much safer bet to try to match your property’s rent with the average rent price for the area and slowly adjust your rates to match the quality (or potential quality) of the asset. Once you’ve made your acquisition, you should regularly compare your rents against similar properties in the area to ensure you’re not overpricing — or underpricing — your units.
From an investor’s point of view, it is insightful to calculate what the property will actually cost you — and then determine if the rent is enough to cover that. To get a better idea of the cash flow, first find the annual sum of the expected rent, then subtract from that figure your monthly mortgage payment, the monthly value of property taxes, the monthly cost of insurance, and a reasonable allotment for maintenance and repairs. Even if you don’t identify any issues needing repairs at the moment of purchase, it is unwise to underestimate these costs.
Making the Purchase
If the figures are desirable after a deep analysis, it is finally time to get your agent to submit an offer. Negotiation between parties can help iron out any pain points the purchase may bring up, and further sweeten the deal. Once the final agreements are made, financing must be secured.
In general, banks are a popular choice, but have tougher lending requirements for investment properties than for the purchase of a primary residence. For multifamily properties with five or more units, agency loans from Fannie Mae, Freddie Mac, or HUD can be extremely beneficial. Even the SBA has a few options for the acquisition of commercial real estate. Regardless of your financing route, have the property thoroughly inspected by a professional third party, and hire a real estate lawyer to review all the documents and details of the transaction before signing.
What are the best financing options for buying a rental property?
The best financing options for buying a rental property depend on your individual situation. Generally, the most popular options for first-time investors are bank loans. Bank loans may not always have the best terms, but they are easier to find and can be recourse loans. Other financing options include FHA loans, VA loans, and hard money loans. FHA loans are government-backed loans that are available to first-time buyers and offer lower down payments and interest rates. VA loans are available to veterans and active-duty military personnel and offer lower interest rates and no down payment. Hard money loans are short-term loans that are backed by the value of the property and are typically used for fix-and-flip investments.
What are the tax implications of owning a rental property?
Owning a rental property can have a variety of tax implications. According to this article, rental income is taxable and must be reported on your tax return. Additionally, you may be able to deduct certain expenses related to the rental property, such as repairs, insurance, and property taxes. You may also be able to take advantage of capital gains tax breaks when you sell the property. It is important to work with a qualified tax professional to ensure that you are taking advantage of all available tax benefits.
What are the most important factors to consider when buying a rental property?
The most important factors to consider when buying a rental property are location, current listings and vacancies, and rent. Location is important because it largely determines the types of tenants the property will attract as well as the vacancy rate. Current listings and vacancies should be researched to understand the area and predict rent scenarios. Lastly, rental income is a key contributor to an investment’s profitability, so it is important to know the target area's average rental rates.
What are the risks associated with buying a rental property?
There are a few risks to consider when buying a rental property. Apartments in general can be notoriously difficult to manage, and this is particularly true for first time building owners. Many owners choose to instead utilize a third-party property management company, which can typically cost between 10-20% of rents (though flat fee arrangements are also often available).
Apartment owners have additional liability risks, especially for larger multistory complexes, and any properties amenities such as pools, gyms, and other areas where accidents may be more likely to occur. Safety inspections and legal compliance issues tend to be both expensive and time consuming (and are something single family home investors rarely have to deal with).
Unlike stock in Amazon or Tesla, apartment buildings are not liquid assets, and can be quite difficult to sell. Even in a seller’s market, it may still take a few months to locate a suitable buyer and close the deal. In a market where prices have fallen significantly, it is often be more desirable to hold on the property for a few years until prices rise again and a suitable profit can be made.
It is highly recommended to buy a reasonably priced property to help ensure a return on your investment. The rule of thumb in the industry is to try to keep the acquisition price within 12 times the annual expected rental income. In regards to appreciation potential, the easiest and most common strategy is to find a property that can take a few, affordable cosmetic changes or minor renovations and command higher rents.
Construction costs have risen dramatically over the past few years, so it is important to do your research and plan ahead with a strong budget before beginning apartment renovations to avoid any nasty surprises. Construction delays are also an unfortunate fact of life, so it may be best to take a very conservative approach in terms of your project timeline. Finally, your renovation work may simply not be enough to get the investment outcome you’re looking for.
How can I find the best rental property for my needs?
The best way to find a rental property that meets your needs is to do your own research. Start by narrowing your focus to a particular MSA or neighborhood and look at the available properties with appreciation potential and an adequate projected cash flow for your goals. Consider the property type, location, size, and amenities, as well as whether you will be actively managing the property or hiring a property management company. It is also important to look at the current listings and vacancies in the area, as well as the rent climate. A good practice is to look both under and beyond your price range, as real estate often sells below listing price. The rule of thumb in the industry is to try to keep the acquisition price within 12 times the annual expected rental income. You may also want to look for properties that can take a few, affordable cosmetic changes or minor renovations and command higher rents. Once you have done your research, you can hire a real estate agent to help you finalize your choice.