10 Tips for Buying Your First Rental Property

Are you considering buying a rental property? While it may seem like easy money, there’s a lot to consider before jumping in — including thorny questions around where you fit in the community, your financial goals, and even your personality! We’ll go over a few of the most important considerations below.

#1: Decide If This Is Really….”You”

Are you handy? There are going to be plenty of tenant issues and concerns that come up — frequently as emergencies. And while you can always call a professional, that does eat away at your profit. Do you have spare cash for those emergencies? If your tenant’s boiler goes out in February, you can’t wait for a paycheck to replace it.

#2: Pay Down Debt First

Pro investors might carry debt as part of their portfolio, but the average first-timer should avoid it. If you have student loans, unpaid medical bills, or children who will soon attend college, purchasing a rental property may not be the right move. It doesn’t mean it’s impossible if you can comfortably make the payments, but remember to always have a margin of safety.

#3: Get the Down Payment

Investment properties generally require a larger down payment than owner-occupied properties, so they have more stringent approval requirements. The 3% you may have put down on the home you currently live in isn’t going to work for an investment property. You will need at least 20% because you can’t buy supplemental mortgage insurance for an income property.

#4: Beware of Higher Interest Rates

The cost of borrowing money might be relatively cheap right now, but the interest rate on an investment property will be higher than traditional mortgage interest rates.

#5: Know Your Margins

Wall Street firms that buy distressed properties aim for returns of 5-7% because they have to pay staff. Individuals should set a goal of 10 percent. Estimate maintenance costs at 1 percent of the property value annually. Other costs include insurance, possible homeowners’ association fees, property taxes, and monthly expenses such as pest control and landscaping.

#6: Don’t Buy a Fixer-Upper

It’s tempting to look for a house that you can get at a bargain and flip into a rental property. However, if this is your first property, that’s probably a bad idea. Unless you have a contractor who does quality work on the cheap – or you’re skilled at large-scale home improvements – you’re likely to pay too much to renovate. Instead, look to buy a home that is priced below the market and needs only minor repairs. Homes that can easily have a bedroom added are great equity builders, too.

#7: Calculate Operating Expenses

Operating expenses on your new property will be between 35 percent and 80 percent of your gross operating income. For an easy calculation, use the 50-percent rule. If the rent you charge is $2,000 per month, expect to pay $1,000 in total expenses.

#8: Determine Your Return

For every dollar you invest, what is your return? Stocks may offer a 7.5-percent cash-on-cash return, while bonds may pay 4.5 percent. A 6-percent return in your first year as a landlord is considered healthy, especially given that number should rise over time.

#9: Get a Low-Cost Home

The more expensive the home, the higher your ongoing expenses will be. Make sure you don’t bite off more than you can chew, especially for your first rental property.

#10: Find the Right Location

When choosing a profitable rental property, look for low property taxes, a decent school district, a neighborhood with low crime rates, and an area with a growing job market and plenty of amenities, such as parks, malls, restaurants, and movie theaters.

Risk vs. Reward

Every financial decision is about weighing the rewards, determining payoff against potential risk. Does investing in real estate make sense for you?

Rewards:

Your income is passive.
Your income should grow over time.
You can put real estate into a self-directed IRA.
Rental income isn’t subject to Social Security tax.
Interest you pay on an investment property loan is tax-deductible.
Short of another crisis, real estate values are more stable than the stock market.
Real estate is a physical asset. Investing in stocks or Wall Street products isn’t anything you can see or touch.

Risks:

Tenants can be challenging to manage.
You may be subject to a 3.8-percent surtax on rental income.
Rent might not cover the total mortgage payment.
Unlike stocks, you can’t instantly sell real estate if the market goes sour.
Unlike stocks, in most cases, you can’t sell a portion of your real estate. It’s all or nothing.
Entry and exit costs are high.
If you don’t have a tenant, you have to pay all expenses.

The Bottom Line

If you’re still ready to purchase a rental home after making your way through this list, be sure to keep your expectations realistic. As with any investment, rental property isn’t going to produce a large monthly paycheck for a while, and picking the wrong property could be a catastrophic mistake. Consider working with an experienced partner on your first property, or renting out your own home to test your landlord abilities. And let us know if you need any help — At Realty Collective, we’ve done this a time or two ourselves.