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A Guide to Your First Rental Property Investment
What's the best time to invest in a rental property? You've probably heard that the best time is now.
The best time was also yesterday. The reality is that there are always good deals in real estate. It only takes a trained eye to spot them. But getting off on the right foot is important if you're still on the outside looking in, looking to get started, and about to buy your first rental property.
When your first property investment is a winner, repeating the success with the second and third one is much easier. Now, we'll show you how to get started and grab those keys to your future financial freedom.
Starting Off with Real Estate Investing
Owning rental property can easily be a stable source of passive income. Legally, rental income is considered passive, even though managing a property does take some effort. If you'd rather not handle the organizational and management aspects of the business, you can always hire a property manager to take care of it for you.
Ultimately, the work gets organized. What real estate investors truly excel at is identifying opportunities before others do—such as finding off-market properties and purchasing them below market value. Investors can either rent out these properties or flip houses by restoring and selling them at higher prices and cashing in on the difference.
Financial Benefits
Investment property comes with all kinds of financial benefits. Let's break them down one by one.
Cash Flow
Rental property owners who rent out their properties on a long-term or short-term basis achieve a steady income stream. In fact, having positive cash flow comes with numerous benefits: it can supplement other earnings and help pay off the mortgage without requiring you to dip into your own funds. You can also reinvest that money into your next rental property.
Long-term Appreciations
Another way to earn from real estate investments is through property appreciation. One of the oldest sayings in real estate investing is that location is the number one factor. This also holds true for appreciation potential. High-demand, high-growth areas, tourist hotspots, and locations with limited supply record the highest appreciation values.
Building Equity and Your Net Worth
When you're buying properties, ownership translates to equity, and equity represents wealth. Anytime you can tap into that equity, you can leverage it and cash out to reinvest in new projects, expand your portfolio, and grow your business. Or just contribute to your retirement fund and save for the future.
Tax Benefits
Yet another reason to invest in real estate is the numerous tax benefits you're entitled to as a rental property owner and investor. We can divide these benefits into three groups:
Deductible: You can deduct taxes on all costs related to property upkeep, maintenance, improvements, and even mortgage interest.
Depreciable: The government allows you to claim deductions for the annual decline in the building's value and depreciation caused by wear and tear.
Deferrable: You can use a 1031 exchange to buy and sell investment properties while deferring payment of taxes until later.
Whenever you sell a property, you must pay taxes on capital gains, unless you decide to reinvest that money by purchasing another property. This is how you defer (postpone) paying taxes, all thanks to the 1031 exchange.
Deciding On Your Investment Criteria
You've decided to purchase your first rental property. How do you decide which property to buy? You won't pick a house randomly just because it looks nice, right?
Define your precise criteria. Think about the location, construction quality, single-family vs. multi-family homes, specific amenities, proximity to important locations, and the influx of tourists in the area. Is the property attractive enough to turn into a rental? Will it be a long-term or short-term rental?
If you plan to rent it out on Airbnb, the location needs to be in demand, so you can expect high guest turnover. Finally, how quickly can you find a buyer if you decide to resell it?
4 Essential Steps to Buying Your First Investment Property
It's time we break down the exact steps you'd need to take to purchase a rental property.
1. Secure Financing
If you don't have a large amount of cash readily available, you will need to take out a loan. The default option is going to a traditional lender, which means a bank. Buying a rental property is different compared to buying your principal residence. Down payments and interest rates are higher.
Credit requirements include a minimum credit score of 620, but higher scores can qualify for better rates and terms. A credit score of 720 or higher is often required for the best loan terms.
Another metric is the debt-to-income ratio, which shows how much of your monthly income goes toward debt. Lenders typically allow up to 75%.
Other types of loans are home equity loans or HELOC (Home Equity Line of Credit). HELOC operates as a revolving line of credit. In these cases, you borrow money against your home equity, which you can use for renovations or investments, not necessarily for buying a new house. You can use that money as a down payment as well. You leverage your home equity to fund your investment.
Down Payment
Usually, the down payment for a loan on a rental home is 20% to 25%. Rental properties are considered riskier than primary residences because borrowers who face financial troubles are more likely to default on an investment property loan. That's why lenders use the higher down payment as a safeguard against potential losses.
Can I Put Less Than 20% Down on an Investment Property?
FHA loans require as little as 3.5% down, but the property must be your primary residence. The same applies to VA loans. If you’re considering house hacking as your rental strategy, you might opt for these types of loans and make a down payment as low as 3.5% or 5%. House hacking often involves purchasing a multi-unit property, living in one unit, and renting out the others.
Similarly, you can bypass the 20% requirement by buying a primary residence and living in it for at least one year. During this time, you qualify for an owner-occupied mortgage. After the one-year mark, you can move out and rent the property.
Alternative Financing Options
You don't necessarily need to go to the bank and apply for a traditional loan. You can invest in real estate using less traditional options. Some of them are:
A lease agreement or lease option allows you to rent a property with the option to purchase it at the end of the lease term. You would rent the property from the seller and may also pay an option fee for the exclusive right to buy it within a specific timeframe. If you want to sublet the property right away without living in it, you will negotiate with the seller to allow you to sublet it in the agreement.
"Subject to" real estate is when you assume the seller's existing mortgage because the seller has difficulty paying it off. You take on the responsibility of paying the mortgage, and the title is transferred to your name. The mortgage stays in the seller's name.
A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-producing real estate. REITs pool the capital of numerous investors, allowing individual investors to earn dividends from real estate investments without having to buy, manage, or finance any properties themselves. However, investing in a REIT does not provide you with direct ownership of the properties.
2. Choose the Market
In rental property investing, location determines profitability. How can you tell the difference between a thriving neighborhood and one that isn't?
Some tell-tale signs give away a great investment location:
- Population growth and the thriving job market.
- The percentage of renter's occupied houses.
- School district quality and other family-friendly local amenities like parks, shopping centers, restaurants, and entertainment facilities.
- Easy access to public transportation.
- Low crime rates.
- The influx of tourists and high occupancy rate for vacation rental investment.
What Type of Rental Property is Most Profitable?
Profitability is often closely tied to the rental or investment model you're most comfortable with.
Single-family homes are a straightforward option for beginners, offering considerable annual cash flow. With a buy-and-hold strategy, you'll earn from monthly rent and long-term appreciation.
House flippers prefer to sell the property right after renovation. They buy distressed houses and renovate them quickly. They usually have a system in place with contractors who can source materials and complete the job at a reasonable price.
What about a short-term rental model? Choosing the right location for your STR investment will yield the highest cash flow possible.
3. Analyze Income Potential
Use metrics like the 2% rule, cap rate, and cash-on-cash return to gauge a property's potential and expected rental income.
The 2% rule states that a rental property is a good investment if the monthly rent is at least 2% of the purchase price, ensuring sufficient profit. For instance, for a property that costs $150,000, you would ideally make profits of at least $3,000 per month.
The cap rate serves to compare properties based on their income-generating potential. It is the ratio of a property's annual net operating income (NOI) to its purchase price or current market value. (NOI represents the total income generated from a property after deducting all operating expenses, but before deducting mortgage payments and taxes.) A cap rate of 4% to 10% is generally viewed as a "good" investment.
Cash-on-cash return measures the annual return made on the cash invested in a property. It is important for any investment, but especially for short-term rentals. If you put down $60,000 in a property and it generates $6,500 in annual pre-tax cash flow, the cash-on-cash return is 10.83% ($6,500 / $60,000 x 100).
4. Purchase
After both parties agree on a property purchase price, it's time to close. But before signing, do your due diligence to be sure there are no hidden surprises.
- Are there disclosures from the current owner?
- Conduct a property inspection. A professional home inspector has the expertise to identify issues that might not be obvious to an untrained eye.
- Is insurance readily available at a reasonable cost?
- Is everything all right with the title report?
- Are there any surprises on the draft settlement statement?
- Ensure the property complies with local zoning laws and regulations, especially if you plan to make any changes or improvements.
- You may need to conduct environmental assessments to check for issues like flood risks or soil contamination.
A real estate attorney can help review contracts and ensure all legal aspects are covered.
Tracking Income and Expenses Like a Pro
"Take care of the pennies, and the dollars will take care of themselves." This holds true for real estate.
Keeping a close eye on your finances helps you stay in control. Plus, it's your best ally when tax season comes. You will claim every possible deduction you're entitled to.
- Operating expenses are the day-to-day costs of operating and maintaining the property, including utilities and repairs.
- You pay annual property taxes levied by the local government based on the property's assessed value.
- Expect some extra maintenance costs, such as regular upkeep expenses for lawn care and appliance servicing.
- Property management companies will charge you fees if you hire them to manage a property on your behalf.
- Property insurance is an expense, but protecting against damages and liability is extremely advisable.
- HOA fees are required by the homeowners association for maintaining common areas and shared facilities.
- Expenses for marketing and promoting the property to attract tenants, including online listings.
- Costs for professional services related to property management, such as drafting leases and the services of accountants, lawyers, etc.
Is Rental Property Always a Good Investment?
Like with every investment, there are times and situations when the odds are stacked against you. To speak frankly, most of these situations are avoided when you're equipped with the right knowledge. For example, when you see markets with high unemployment rates where major employers are leaving or shutting down, it's a red flag from an investment standpoint.
Properties with structural issues that require extensive repairs exceeding 20-30% of the purchase price are probably not worth investing in.
If tourists rarely visit a place and the high season is extremely short, there's no point in renting it out on Airbnb. A monthly rental income of less than 1% of the property's purchase price is likely insufficient to keep your business sustainable.
To get started, you need to save some money first. Build an emergency fund that covers the first 6-12 months of expenses, just in case.
Final Tips for Long-Term Success
Equity in real estate is a great asset that builds wealth. But there's another asset that often gets overlooked: your time. You need time to be a landlord and take good care of tenants. If you prefer vacation rentals, you'd better be well-organized, or you can find yourself all over the place with guests checking in and out nonstop.
Short-term rental investment may bring the highest cash-on-cash return, but keeping guests satisfied and the property pristine is a daily grind—unless you have some help. Why not leverage technology?
iGMS is designed for busy hosts and investors who want to manage things on the go, also from their phones. Schedule cleaners, keep booking platforms synchronized, oversee all guest communication, and let the program send check-in instructions and other messages automatically.
