How To Buy Your First Rental Property in Any Market
Buying your first rental property is an exciting step toward real estate investing. We’ll show you how to do it in this step-by-step guide!
Buying your first rental property is an exciting time.
But where to start?
In this guide, we’re going to break down each of the steps, the pros and cons of owning a rental property, and the right expectations you need to have if you want to make this business work for you.
Should You Buy a Rental Property? Setting Realistic Expectations…
If you think you’re going to generate $10,000 a month in rental income by next year, you’re setting yourself up for disappointment.
In fact, that’s not really the point of buying rental properties.
What makes investing in rental properties so attractive is the long-term potential.
By building a portfolio of rental properties, you can increase your net worth, invest into assets, and even create generational wealth.
The best part?
Your tenants are paying for the equity and wealth you’re building.
And any cash-flow that’s being generated should be stored in reserves for things like maintenance, expenses, vacancies, etc.
Which brings us to our next point…
The Pros & Cons of Buying Rental Property
Before you begin any investing strategy, you need to weigh the upside against the potential downside and risks that come with it.
Let’s take a look at the pros and cons of buying rental properties.
PRO: They Appreciate & Build Equity
In terms of generating long-term wealth, it’s hard to beat a portfolio of rental properties. As your rental properties appreciate, your net worth appreciates also.
Not to mention the equity you’re building… which you can leverage down the road for other investments or even for retirement.
CON: Rentals Require Cash and/or Credit
When buying rental properties, you’ll need cash for the down payment and a credit score worthy of getting the loan. You’ll also be required to carry extra insurance due to the liabilities you incur when you’re letting tenants rent the property from you.
PRO: You Get Some Tax Benefits
One of the biggest perks you get as a rental investor is all the added tax benefits. Deductions like mortgage interest, repairs, maintenance, insurance costs, property management fees, etc, can all add up at the end of the year.
On top of that, there’s other tax strategies you can take advantage of, like using depreciation to offset your income, big improvements that you’ve done like a new roof or a kitchen remodel, and pushing your capital gains taxes back.
CON: Managing a Rental Property Takes Work
New investors often fail to realize how much work goes into owning a rental property.
Since all this work goes on behind the scenes, the rentals you own could quickly turn into a second job for you when it comes time finding tenants, maintaining the property, getting emergency repairs done, etc.
Which, if you’re not working with a property management company, this work falls on you. That means your vacation can be interrupted because a pipe burst in the property and you have to respond.
PRO: Rentals Can Protect Against Inflation
When it comes to inflation, rent prices tend to grow as the inflation number grows.
As a landlord, you can raise your rent year-over-year to make sure you’re staying on pace (or even beating) inflation. So no matter how bad the economy may get, rental properties are historically a good buffer.
CON: Bad Tenants Can Cost Thousands
As the owner, you’re at the mercy of your tenants.
If you put great tenants in the property — ones who treat the home like it’s their own — you’re generally going to have a good time renting the property to them.
However, if you end up renting to bad tenants, you could be at the risk of them trashing the place, forcing you to evict them, and dealing with attorneys fees, vacancy costs, and renovation costs incurred by having to repair the damage done.
How To Calculate The ROI on a Rental Property
To understand your ROI on a rental property, you need to factor in all of your expenses (including mortgage) and subtract it from the rent you receive every month.
At its most basic, your cash flow is your rental income minus your expenses.
So if your income is $1,500 a month, and your expenses are:
- Mortgage: $1,000
- Taxes: $200
- Insurance: $125
- Management: $150 (Usually 8-10% of your rental income.)
Then your income is $1,500, your expenses are $840, and you’re cash flowing $135 a month.
But the number you actually want to look at is your cash-on-cash return. This will give you a general idea of how well a property will perform. To get that number you need to look at your annual cash flow and divide it by your initial out of pocket.
As Investopedia defines it,
“A cash-on-cash return is a rate of return often used in real estate transactions that calculates the cash income earned on the cash invested in a property.”
In this example, you’re cash flowing $135 a month, or $1,620 per year. If you put $20,000 out of pocket to secure the property, you’re looking at $1,620 divided by $20,000.
That gives you a 8.1% cash-on-cash return.
That’s not bad since, as a general rule of thumb, you want to make sure your cash-on-cash return is at least 7% if you want to beat more traditional investing strategies.
10 Steps to Buy Your First Rental Property
Let’s get into the steps you can take to buy your first rental property… even if you don’t have a lot of cash on-hand.
Step 1. Consider House Hacking (Optional)
With house hacking, instead of purchasing a single-family residence, you’ll actually be looking for multi-family properties like duplexes, triplexes, quads, or small apartment buildings.
When you’re using this strategy you will be living in one of the units while you’re renting out the others -- typically after renovating them so you’re able to charge higher rents. Then, the goal becomes to live rent-free while building equity in the property.
Step 2. Secure Financing
The next step is understanding how much money will be required for you to secure pre-approval on funding the deal before you can move forward.
As a general rule of thumb, expect to need around 35% of the purchase price in cash.
- 20% for your down payment.
- 3% for closing costs.
- 10% for initial maintenance and repairs.
- 1% per month for holding costs until you find tenants.
Once you have that 35% in hand, you’ll know how much you need to borrow. That’s when you can use options like seller financing, private lenders, investor partnerships, or other types of loan that are available for rental properties, like:
- Conventional: This is going to be the most common route for new investors. A conventional loan offers lower interest rates and fees but does require you to have a good credit score and a down payment ranging from 15% to 25% of the loan value.
- FHA for Investment: FHA and VA loans are available for multi-family properties, making them a great strategy if you’re going to be house hacking and living in the residence. These loans often have lower requirements but do require you to live in the property for at least one year.
- HELOC: A home equity line of credit can be used if you already own a home, have equity built up, and are looking to upgrade your residence. With a HELOC, you will borrow against the equity, use it to fund the new purchase, and then move into the new residence -- while renting out your first.
- Seller Financing / Assuming The Mortgage: With seller financing and assuming the mortgage, you are leaving the property in your seller’s name while being able to rent the property out to tenants that you’ve chosen. Then you pay the mortgage on the property in your seller’s name while cash flowing the difference.
- Private Lenders / Investor Partnerships: If neither of those options are available to you, you can still acquire the down payment by working with private lenders, like family and friends. You’re also able to work with other investors who know a good deal when they see one and are willing to front the money for the down payment -- with the expectation of being repaid at a rate of 8 to 12% per year, in many cases.
- Subject To: If none of the above options are available, you can use a “subject to”. This means the seller keeps the deed in their name and allows you to take over payments on an existing loan with no down payment required. You can do what you want with the property as you create a contractual agreement with the owner.
Step 3. Find a Great Deal
The best way to make money through real estate investing is to find a good deal.
As many savvy investors have said, “you make money when you buy.”
If you get a great deal upfront, then the rest will take care of itself.
This usually means finding the deal yourself, performing due diligence, and securing the property without an agent.
This can save you thousands of dollars in the long-run.
To do this, you’ll want to pull a list of properties (using the lists in this guide) and begin sending targeted mailers to them. That guide also shows you how to make your mailers as effective as possible.
Outside of that, you can go driving for dollars, knocking on doors, making cold calls, etc, to find properties that you want to buy.
Then, once you’ve found the properties, you’ll need to analyze them to make sure they’re a good deal.
You want to know that you’re paying a fair price for the property and that you’ll be able to rent it out for more than what you’ll pay in expenses like your mortgage, taxes, repairs, and management fees.
Use the cash-on-cash return formula we gave you above to determine whether or not the deal makes sense and if you should move forward.
Then look at the purchase price of the property so you can get an idea of the mortgage cost. Is what the seller is asking for a fair price in comparison to the homes around it?
Step 4. Make an Offer & Negotiate
The first basic rule of making an offer and negotiating is never go above your max offer calculations.
If the numbers in the deal don’t make sense, walk away. There’s no property worth taking a risk on and paying more than your max offer calculations said you can afford to pay. There’s always other deals.
Step 5. Close
When it comes time to close, you’ll need to start working with your title company, signing the contracts, and getting the deal finalized so you can secure the property.
Step 6. Use The BRRRR Method (Optional)
Once you’ve taken possession of the property, the door to grow your long-term wealth even faster starts to open with strategies like The BRRRR Method.
It stands for “Buy, Rehab, Rent, Refinance, Repeat” and lets you essentially secure the property, perform renovations, get tenants in place, and then refinance the property at the new, higher value (due to appreciation and the rehab).
When you refinance, you’ll be able to take out the equity you’ve built up as cash and pour that back into your next rental property, letting you scale your portfolio much more quickly.
Step 7. Consider Working With a Property Management Company
Unless you’re looking to create a second job for yourself, you want to work with a property management company.
Think back to our example of a pipe bursting in the house while you’re on vacation. Do you really want to be dealing with that while you’re relaxing? Or do you want to pay someone else to manage the headache for you?
Since most property management companies operate on around 10% of your monthly rent, you should definitely factor this into your operating expenses and consider it an extremely wise investment.
Step 8. Don’t Forget About Management Costs
Never consider the cash coming through your rental properties as your own cash.
Instead, keep it in a reserve account that’s designated solely for the upkeep, maintenance, and expenses your properties are going to incur, as well as the cost of those properties being vacant in between tenants.
Whether it’s tenants breaking stuff, stuff breaking due to age, or general wear and tear, the cash you generate needs to be saved in reserve.
Step 9. Include These Clauses in Your Rental Contract
In many states, tenants have more rights than property owners do. That’s why a rock-solid contract is your best security as a rental investor.
You can protect yourself by including the right clauses in your contracts.
Check out the video below to see a few clauses you should include in your rental contracts.
Step 10. Find Good Tenants
It’s better to lose a bit of money from a vacant property than it is to have your house destroyed by bad tenants. Vet them. Ask good questions. Check references.
If you get a bad vibe, reject their application.
Otherwise, you may find yourself in a position where you’re losing money on attorneys, lost rent while you’re waiting to evict them, and the added expense of having to renovate the property again when you do finally get them out.
As long as you adopt the right mindset, take a long-term approach to your strategy, and follow the steps we’ve outlined for how to buy your first rental property in any market, you’re primed for building an investing business that creates real generational wealth for you and your family.
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