Monday, 24 June 2019

A Guide to Buying Your First Investment Property

A Guide to Buying Your First Investment Property
23 Dec
6:28

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Investors looking for a way to diversify their portfolios usually explore the idea of purchasing real estate at some point. Doing so can help them invest for the long haul without putting all their eggs in one basket. Plus, investing in real estate may come with some serious perks — including the potential for somewhat passive income.

If you’re wondering how investing in real estate might benefit you, it’s important to understand the financial mechanics behind such a transaction. Investors typically purchase real estate with a few different goals in mind:

  • Buying a property to remodel and sell for a profit
  • Buying property to rent out at a profit (becoming a landlord)

For the purpose of this guide, we’re going to focus mostly on the second endeavor — buying real estate with the goal of renting it out. Keep reading to find out why people buy investment property, best practices for maintaining a profitable rental property business and how to know if becoming a landlord is right for you.

Why buy investment property?

The main reason so many people dive into rental real estate is simple. Potential landlords hope to purchase properties at an affordable price then rent them out to tenants each month. Ideally, landlords hope to earn enough rental income to cover the mortgage, taxes, insurance, maintenance and repairs, as well as turn a profit every month. Many people who buy investment property do so for the long haul — as in, they keep their rentals for decades and let their tenants pay them off with their monthly rent payments.

Mindy Jensen, a residential landlord and community manager for real estate website BiggerPockets.com, said you can generate wealth through real estate in a few different ways — cash flow, appreciation and equity paydown. Cash flow is the amount of income you generate monthly, appreciation is what happens when the value of your property increases over time and equity paydown is what happens when your tenants are paying your mortgage for you, she said.

Jensen noted that, for the most part, real estate investing is a long-term game. “Some people view it as a get rich quick scheme, and those are the people who are most likely to fail,” she said.

In addition to the financial potential that comes with investing in real estate, some investors see becoming a landlord as another way to diversify their portfolios away from the stock market and other investments that are less tangible — less “real.” Where the stock market seems out of reach and out of an investor’s control, rental real estate is an investment you can see and touch.

Some investors may feel that investing in real estate is a smart way to hedge bets against the volatility of the stock market as well. After all, no matter how bad the economy gets, everyone will need somewhere to live.

With all this being said, it’s important to make sure you’re investing in real estate with the right mindset. As Jensen noted, investing in real estate typically works best when you’re in it for the long haul. We’ve all seen popular television shows where everyday people “flip houses” or remodel them for profit, but the stories aren’t always as cheery and positive in the real world. You can make money quickly by remodeling houses and selling them, but you can lose money just as easily.

It’s also important to understand that, if real estate is a long-term game, you have to be prepared to deal with upkeep and repairs — financially and otherwise. You will also have to deal with finding new tenants from time to time, organizing ongoing maintenance, and dealing with issues that crop up. If you want an investment you can “set and forget,” real estate is probably not for you.

Am I ready to buy an investment property?

Before you dive into rental real estate, it’s important to make sure you have your financial ducks in a row. There are myriad upfront costs to prepare for when you buy rental real estate, but there are also ongoing costs to be aware of. Not only that, but you’ll need to have a basic arsenal of skills to be a landlord.

Here are the main details to be aware of before you buy an investment property.

Be prepared to pony up a big down payment

While down payment requirements can vary depending on your credit score and other factors, you typically need to put down 15% to 25% of the purchase price of a rental property upfront. While this may not be a difficult feat in an area where real estate prices are low, you can imagine how cumbersome it might be to purchase investment property in a high-cost-of-living area.

Of course, it is possible to purchase investment property with a smaller down payment if you’re prepared to live in it. Chad Carson, who is a real estate investor and the author of “Retire Early with Real Estate,” said some investors purchase multi-family properties using mortgage programs that let them put little down. Consumers buying a duplex could opt for an FHA loan with a down payment of only 3.5% if they qualify, for example. They would be required to live in one side, but they could rent the other side out for a profit.

Save up for ongoing maintenance and repairs

You will also need to have money set aside to cover ongoing maintenance as well as the replacement of major components. Maintenance can include expenses such as:

  • Having a HVAC system serviced and cleaned annually
  • Ongoing lawn care
  • Painting and cleaning
  • Lightbulbs, furnace filters
  • Carpet cleaning

In addition to ongoing maintenance, you’ll also need funds to cover expensive repairs such as a roof or new furnace. However, how much you need to save for major components can vary since you may need less saved upfront if you purchase a property with a new roof and HVAC system, said Jensen.

Also note that some things will seemingly pop up out of nowhere when you’re a landlord, and you need to have the funds ready and waiting. You may have a tenant damage your property substantially, in which case you’ll need to have money for needed repairs so you can fix your property back up and rent it out again. Your rental may also go several months or longer without a tenant, which will leave you in a position where you have to cover the mortgage payment and maintenance costs without any rent coming in. If the worst-case scenario plays out, a tenant might stop paying rent altogether.

Jensen suggested setting aside a fund of $5,000 to $10,000 whenever you buy a property. That way you’re covered if you need to make a major repair right away.

You should also set aside some money every month to pay for maintenance and repairs, although how much you should save depends on the type of property you’re buying and what you anticipate having to fix or replace. As a rule of thumb, many landlords set aside 10% of their monthly rental income to cover maintenance and repairs. If a property rents for $2,000 per month, for example, they would set aside $200 per month in a separate savings account earmarked for this purpose.

Don’t forget about taxes and insurance

In addition to covering maintenance and repairs, you’ll also need to account for property taxes and landlord’s homeowner insurance. These costs are typically wrapped into your mortgage payment via an escrow account, but you still need to anticipate them when you’re figuring out whether a particular property would be profitable as a rental.

You can find out how much property taxes cost by checking the home you’re interested with the local MLS, or Multiple Listing Service. You can also ask a real estate agent you’re working with to help you find this information. Keep in mind, however, that your property taxes may cost more on a rental property, since many states set separate caps for property taxes on primary residences and investment property. In Indiana, for example, property taxes are capped at 1% of the assessed property value for owner-occupied properties and residential investment property is capped at 2%. That could mean your property taxes double from what is listed in the MLS after a home is converted from someone’s primary residence to a rental.

To find out how much insurance will cost for a specific property, you can call a local insurance agent (or several) to get a quote. Remember that your property insurance costs will vary depending on where you live, the size of the home, additional buildings and upgrades to the property, your chosen deductible and your chosen coverage limits.

Don’t forget about other skills required

In addition to making sure you are financially prepared to become a landlord, there are other important skills to master. You will need to have a system to keep track of receipts, payments and other financial transactions you make, for example, and this requires some organization. You will also need to be able to purchase or draft up a lease, and you will need to have some idea of how to find and screen tenants. You can hire a property manager to oversee many of the aspects of owning rental property for you, but you will still have to be able to search for one and work with them on an ongoing basis.

Knowing how to perform basic upkeep and repairs can also save you considerable sums of money when you’re a landlord. If you’re willing and able to unclog a drain, replace a leaking faucet, or lay new flooring on your own, you can save a ton of money versus paying someone to perform these tasks for you.

What type of investment property should you buy?

When it comes to deciding on the type of property to buy, there are several factors to consider. For example, do you want to live in one unit of your property and rent out the others? Or, do you prefer to purchase a single-family home? A larger apartment building? Only you can decide which way to go as a real estate investor.

Carson said single-family homes and small apartment buildings with four or fewer units are his favorite investments, because they are “easy to finance, easy to understand and very flexible.” He also said buying a multi-family property and living in one unit is a great way to get your feet wet as a landlord.

In fact, one of Carson’s first real estate investments was a four-unit apartment building. He lived in the smallest unit and rented out the other three. The rent from the three units he rented out covered 100% of his expenses, so he was basically living for free. Carson said this is what real estate nerds call “house hacking.” Carson moved out of the property after a few years, but he still owns it.

Jensen said she prefers single-family homes she can use to build wealth. When she buys a single-family property, she often moves into it, rehabs it and lives there for two years. Jensen uses this strategy because, thanks to IRS tax laws, you can typically avoid paying capital gains on up to $250,000 for singles and $500,000 for couples filing a joint return when you live in a property for two of the last five years before you sell.

Carson said a “smart” investment property buy is one where the numbers make sense no matter whether it’s a single-family home or a multi-unit property.

“Don’t just buy a big, beautiful dream home,” he said. Instead, run the numbers and find a property that also makes sense as an investment.

“Sometimes the best investments are simple, boring properties that are shaped like a box!”

Finding a home to buy

This leads us to the next big question in real estate investing: How do you know if a property will be profitable or not? At the end of the day, this depends less on purchase price and more on local rents in your area and the ongoing costs associated with each unique property. In other words, it may make sense to buy a more expensive property if rent prices can justify the purchase.

Many real estate investors use what’s known as the “1% rule” when searching for properties to buy. This rule implies that you can rent out a property for 1% of its purchase price (e.g. a $250,000 property that rents for $2,500 per month). The concept behind this rule is that earning 1% of the purchase price in rent each month is usually enough to cover the mortgage, taxes, insurance, and upkeep and repairs with plenty of cash flow left over as profit.

Carson said he uses the 1% rule as a preliminary way to vet potential properties. If he stumbles upon a property that could rent for 1% of the purchase price, that’s a good sign he should dig deeper.

Before he makes an offer, however, he runs a more detailed analysis. “I want to know how much income a property will actually produce after all expenses, including my mortgage,” he said. Carson said it can take him a week or more to come up with the numbers he needs to determine whether a property will be profitable or not.

Jensen said that, although the 1% rule is a smart rule of thumb, it is impossible to achieve in many markets where real estate prices are high. Jensen notes that, where she lives in Colorado, properties are renting out for more like 0.5% or 0.6% of the purchase price. On the other hand, she also owns a mobile home park in Maine she expects to bring in approximately 1.3% in rents next year.

The key to finding a profitable property is making sure all your expenses are covered with some profit leftover. For example, let’s say you’re considering purchasing a $150,000 rental property that could rent for $1,500 per month or more based on rental prices you’ve found by researching similar properties in your area. The property has a newer roof and HVAC system so you don’t anticipate any big expenses you’ll need to save up for right away. Your expenses for this property could look like this, provided you did bring in $1,500 per month and took out a mortgage of $120,000 at 5% APR (after $30,000 down payment):

  • Mortgage payment of $1,019 per month, assuming $1,500 in annual homeowner insurance payments and $3,000 in property taxes annually
  • $150 set aside monthly for future maintenance and repairs
  • Monthly cash flow of $331

In terms of where to find properties, you can search for investment real estate in several ways. You can link up with a local real estate agent who has their finger on the pulse of the market you want to buy in, for example. You can search local real estate magazines and newspapers for new listings, and you can search the MLS in your target area.

Financing your first investment property

We already mentioned how you typically need to put down 15% to 25% to buy a single-family or multi-unit property with a conventional mortgage. Jensen noted that, while coming up with a big down payment may be difficult at first, putting down at least 20% with a conventional loan can help you avoid the additional costs of private mortgage insurance, or PMI. If you can’t come up with 20% to put down, on the other hand, put down as little as you are allowed, since you have the right to ask your lender to remove the PMI once you have 20% equity in your property. Keep in mind, however, that you may need to pay for a new appraisal to prove you have 20% equity in your property.

Carson said that, if you’re buying an investment property you don’t plan to live in, he recommends finding a good mortgage lender who specializes in investment loans. You’ll have to put up to 20-25% down, he said, but you can still get 30-year, low-interest loans if your credit and income are good. You will likely also need considerable cash reserves (usually six months of mortgage payments) on hand to qualify for a rental property mortgage.

If you’re buying a property with more than one unit like a duplex, on the other hand, you may want to consider an FHA loan, since FHA loans allow consumers to purchase properties they plan to live in with as little as 3.5% down if minimum credit requirements are met.

Another way to finance all or part of an investment property is by taking out a home equity loan or HELOC on your primary residence and using the funds for a rental property. This strategy will only work if you have considerable equity in your home. Plus, you are putting your own personal residence on the line, because you’re using your home as collateral for the loan. If you don’t repay your home equity loan or HELOC, you could lose your primary residence to foreclosure.

Finding your first tenant

So, you’ve purchased a rental property. Now what? Once you’ve successfully closed on your property and have the keys in your hand, you can start looking for the ideal tenant to occupy your investment.

This part of the process can be stressful, because tenants play such a huge role in the financial success of your investment. A good tenant can help you earn greater returns by taking care of your property, but a bad tenant who damages your home or doesn’t pay rent can cost you in more ways than one.

Once you’re ready, you can post online real estate listings on websites like craigslist.org or in local Facebook groups. You can also place signs in the yard or run an advertisement in local newspapers in order to find tenants.

Jensen suggests holding a rental “open house” that you advertise with signs and your online or newspaper listings. The open house will create a sense of urgency for potential renters, and it could prevent you from wasting your time on people who make appointments to see the property but never show up. (Spoiler alert: Jensen said that there are always a ton of no-shows!)

Ideally, your rental open house will attract several qualified renters ready to rent your property. Fortunately, you can find out everything you want to know about a potential tenant by having them fill out a rental application (you can find them for free and print them online) and using it to run a credit and background check. You can even use a service like MyRental.com that lets your tenants apply online then conveniently runs credit and background checks for you (for a fee). Experian also offers tenant credit background checks with no fee, and you can complete the entire process online.

While there’s no exact science to find the perfect tenants, here are a few signs to look for in a renter:

  • A decent credit score (650 to 700 or higher)
  • Enough income to cover the payment (usually at least three times the rent)
  • Positive landlord references
  • Proof of employment
  • History of no evictions
  • No violent crime convictions

While these are all positive attributes to look for in a potential renter, keep in mind that the Fair Housing Act prohibits landlords from discriminating against renters based on:

  • Race or color
  • Religion
  • Sex
  • National origin
  • Familial status
  • Disability

While screening tenants can seem like a big upfront investment of time and some money, Jensen said this part is crucial. “The more work you put in upfront, the less likely you are to have problems down the road,” she said.

Also note that you can have your property manager conduct the search for tenants for you. We’ll go over the pros and cons of hiring a property manager in depth in the next section.

Maintaining your first investment property

We already talked about how much money you need to budget to maintain your rental properties, but how much time do you need to budget? Like most questions having to do with real estate, there’s no firm answer that applies to everyone.

As a landlord, you may have months or years where you hardly hear from your tenants at all and other stretches of time where it seems like everything is going wrong. Overall, how much time you’ll need to spend depends on whether you opt to take care of small repairs on your own or outsource all the work.

Imagine the kitchen faucet starts leaking at your first rental property within a few weeks. Will you get in your car and drive there so you can attempt to fix it yourself? Or, will you call a plumber and let them handle it? While the first option may take up a few hours of your time, the latter could take less than five minutes. These are the factors you’ll want to consider as you determine how much of your time you’ll spend on your property.

Either way, you should make sure you’re planning for ongoing maintenance and repairs — even if you don’t perform them yourself. Remember that homes of all sizes require some very basic maintenance to keep them in good shape and ward off pricey repairs. As an example, you can negotiate with your renter to have them mow the grass themselves or hire someone to do the mowing and include it in their rental cost, but most renters aren’t going to do basic maintenance like cleaning out the gutters or clearing out flower beds. You’ll also want to make sure your HVAC filters are changed regularly, whether you provide them and ask your renters to do it or stop by to do it yourself.

And, what about water filters that need changed? Homes with pools that need ongoing maintenance and upkeep? Properties with sprinkler systems or home security systems? Homes that sit on farmland or property with acreage? These are a few examples of situations where additional maintenance could be required, and there may be other maintenance considerations to prepare for, depending on the property you buy and where it’s located.

If all of this sounds overwhelming to you, keep in mind that you can hire a property manager to do most of the grunt work for you. Property managers can help in a variety of ways, including:

  • Finding and screening tenants
  • Dealing with tenant issues
  • Collecting rent
  • Coordinating repairs
  • Coordinating ongoing maintenance

Hiring a property manager may seem like a dream come true, right? Who wouldn’t want someone to do all the landlord grunt work for them while they sit back and collect the checks?

Of course, you will have to pay for this help. Most property managers charge approximately 10% of the monthly rent of each unit, which can eat away at your returns and could even cause you to lose money on your investment.

Many people feel this is too expensive and try to do it by themselves, said Jensen. “However, not everyone is suited to being a landlord.”

If you do decide you need help overseeing your first rental, she suggests checking out the National Association of Residential Property Managers at narpm.org.

Carson said that, if you don’t mind spending your time and effort dealing with your rental business, there’s nothing wrong with starting off doing the management yourself. This is particularly true if you have some basic plumbing and electrical skills, and if you’re willing to clean and paint.

However, it’s possible a property manager could let you run your business like a true investment. Carson said he was able to travel to Ecuador for 17 months because he hired property managers to deal with his various investment properties. He obviously wouldn’t have been able to leave the country for that long without outside help, so it made sense for him at the time.

The bottom line

Buying rental property can make a lot of sense if you’re eager to diversify your investments and willing to try something new. However, there is a lot of work involved — some of which you may not truly understand until you’re living the landlord lifestyle.

The key to making sure you’re ready to become a landlord is preparing yourself financially and mentally so you’re able to juggle the financial and emotional aspects of becoming a landlord. Having a hefty down payment is one thing, but you also need cash on-hand to handle expected and unexpected maintenance and repair costs as they come along.

As a final note, you should also learn to expect the unexpected when you own investment property. Your tenants will surprise you, and not always in the ways you’d expect. Even the nicest people can damage your property or lose their job and stop paying rent, and some renters might ring your phone with issues or questions at all hours of the day and night. These situations can take a toll on your mental health, drain your financial resources, or both.

Your best bet as a landlord is making sure you’re prepared to handle anything that comes your way. Have plenty of cash in the bank and plenty of patience. You’ll need both.

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