Many of the world’s wealthiest people have real estate to thank for their fortunes. For this reason, a lot of people are drawn to owning investment properties in order to build their wealth. If you’re interested in learning about investing in rental property for beginners, you’ve come to the right place.
Owning rental properties can offer tax benefits, produce income, and be a great way to diversify your investment portfolio.
However, it can also be a lot of work. For that reason, it’s important to do your research before jumping in. If you’re just starting your journey into real estate investing, stick with us while we look at everything you should know.
Buying a property is always a big decision, and rental property is no exception. Let’s take a look at some of the steps you should take before you purchase a rental property.
One of the first things you should consider when you are thinking about buying a rental property is whether or not you are cut out to be a landlord. A lot of people online make it sound like owning rental property is an entirely passive way to make income, but that really isn’t the case. There is a lot of work involved in owning rental property, and while you can reduce how hands-on it is by hiring property management, it still isn’t always a walk in the park. In general, the more properties you have, the more financially justifiable it is to hire property management.
If you choose to manage your properties on your own, you are taking on responsibility for a number of different tasks. These include:
Being a landlord is basically operating a small business. You will also need to deal with your own taxes, income, bookkeeping, and more.
Of course, the type of property and the location of the property can have a big impact on how demanding it is to be a landlord. If you buy a fully-updated home that has been well-maintained in an in-demand neighborhood, you might find that you have high-quality, long-term tenants that don’t cause you much trouble and that the house itself doesn’t require much beyond regular maintenance. On the other end of the spectrum, buying a beat-up house with problematic tenants could cause you headache after headache, demanding a ton of your time and causing you a lot of stress.
At the end of the day, you want to determine whether or not being a landlord is something that works for you. There are many people out there that love being a landlord, while others try it out and find it’s not their cup of tea. Before jumping in, it’s a good idea to really think about what it would entail, the time commitment it would require, and whether or not this is a job you want to take on. Remember, of course, there are other ways to invest in real estate other than owning rental properties.
Another step you’ll want to take before you start making offers on rental properties is to make sure your finances are in order.
It’s generally advised that you pay down any personal debt you are carrying before you buy a rental property. It might not be the right move for you if you are dealing with a lot of unpaid bills, credit card debt, student loans, or are planning on paying for your kids' college soon.
Of course, only you can decide whether or not buying a rental property is the right choice when it comes to building your financial health. Some people might choose to purchase their first rental property even when they have debt because they are certain that the return they will receive is greater than the cost of the debt. That being said, it’s always a good idea to have saved up an emergency fund to ensure that you will always be able to make payments toward your debts if something unforeseen happens.
As a newbie in the world of real estate investing, you might be assuming that you only have to save up 3-5% for your downpayment to buy a rental. Unfortunately, this isn’t the case. In general, lenders have more strict approval requirements if you are planning on buying the property with a mortgage.
Since mortgage insurance isn’t available on rental properties, you’ll usually have to put down at least 20% as a down payment. While you might be able to get these funds through a personal loan or other avenues, you’ll want to make sure the lender you are thinking of working with would be ok with this.
The next step in buying your first rental property is figuring out the perfect location for the property. If you are going to purchase a rental in the city you’ve lived in your whole life, you can capitalize on the wealth of on-the-ground knowledge you’ve picked up over the decades. That being said, it’s still a good idea to zoom out and look at various neighborhoods in your area from a more objective, analytical lens.
There are a number of things you’ll want to look for in a good rental property. While your list of criteria might look a little different than the one we provide below, some of the characteristics you might want to look for include:
Buying rental property is a long-term investment. When you are considering the location, you don’t just want to look at what a specific neighborhood is like now. You’ll want to try and peer five, ten, or twenty years down the road and determine whether the location is on the up and up or on its way out.
The location you choose will have a lot to do with the quality of tenants you get. Ideal tenants have a steady income, have good references from past landlords, and will stick around for a while, among other things. If you want to attract this type of tenant, you will want to pick a location that is appealing to them.
There is an ongoing debate in the world of real estate investing regarding whether it’s better to buy a property outright with cash or to finance it with a mortgage. There are pros and cons to each strategy, but it’s a good idea to decide which route you will take as this will determine your budget for purchasing a property.
On the one hand, buying a property in cash means you don’t have to go through the arduous mortgage process and can also save money on closing costs (not to mention save you money on interest over the life of the loan.) This also means that the process of purchasing the rental can be much shorter from start to finish. Paying in cash lets you create a healthy, positive monthly cash flow right off the bat, which might not always be the case with a property you buy with a mortgage.
On the other hand, though, you might be able to get a higher return on your investment if you buy a rental with a mortgage. While your cash flow will be lower because you have to make monthly mortgage payments, you could potentially buy a much more expensive rental property using the power of debt. It also means that the annual return on your investment can be higher because you are reaping the benefits of a more expensive property even though you only invested somewhere around 20% of the purchase price.
Another factor you’ll want to consider when you’re a beginner in the world of real estate investing is what type of rental you want to own.
First of all, you’ll want to think about whether you’d rather own a long-term rental or a short-term rental. There are pros and cons to each path, and only you can decide what makes sense for you.
Short-term rentals (also known as vacation rentals) are rented out to short-term guests rather than long-term tenants. Short-term rental property owners often use sites like VRBO and Airbnb to list their rentals. If you are in a location that is in demand for short-term rentals, it can be more lucrative than long-term rentals.
Vacation rentals are a popular choice for beginner investors because it allows you to experiment with the format without investing too much. For example, if you live in a desirable vacation location, you could rent out an extra room or an in-law apartment on your existing property to get a sense of what it would mean to own a rental property.
However, there is generally more risk involved in short-term rentals because there are more people staying in your home than with a traditional rental. It’s also worth noting that people tend to behave differently when they are on vacation, and you might, unfortunately, find that your cute little rental has become party central in a way that leads to damage, noise complaints, theft, and headaches all around. Additionally, there’s more effort involved in running a short-term rental as well as more maintenance costs.
Long-term rentals, on the other hand, are what you typically think about when you think of owning a rental property. Also known as traditional rentals, this is when you buy a property and rent it out to tenants using a lease. This type of rental can definitely be more hands-off than short-term rentals, particularly if you find awesome long-term tenants.
In general, most of the commentary and advice in this article is about long-term rentals rather than vacation rentals.
Beyond the short term vs. long term question, there’s also the matter of the type of property. These include:
Single-family homes can be an accessible place for new real estate investors to begin, as purchasing a huge apartment building right off the bat might leave you feeling like you are in over your head. On top of that, buying a single-family home might be the most affordable option for a new rental property investor. However, the more units that can be rented out in a building, the higher cash flow and ROI you can generally receive.
When you're shopping around for rental property, you might get enticed by the idea that you can save money on your purchase by buying a foreclosed property. While this might be the case in some circumstances, you'll definitely want to familiarize yourself with the risks of buying a foreclosed property.
Lastly, it’s worth mentioning that buying and renting out commercial property is another option. It’s an entirely different animal than renting out residential property, though, so it would be wise to seek out resources and forums that are dedicated specifically to that investment tactic if you’re interested.
NOTE: You should check out our article on how to value a property based on the income that it earns. It's a critical part of your investment property strategy.
Finally, there’s really no such thing as too much research when you’re thinking about buying a rental property. Purchasing rental property could end up being the best financial decision you ever made or could turn out to be a complete nightmare. This is because there are a lot of things that can go wrong with rentals, some of which can be financially ruinous.
You’ll definitely want to know the landlord-tenant laws in your state and municipality like the back of your hand. Some cities and states are much more friendly to landlords than others, while some heavily favor tenants in their laws. The laws in your state and city can have a very real impact on what it means to be a landlord and how lucrative your real estate empire can be, so this isn’t a step you’ll want to skip. Consider reading some worst-case-scenario stories online about rental properties in your state to understand the potential downsides of real estate ownership.
Familiarizing yourself with the location as well as the property is also essential. If you buy a real estate property on a whim, you’re essentially flipping a coin. Some landlords have excellent luck despite never putting much research into the properties they buy, and good for them. For others, though, the choice to avoid doing their due diligence is incredibly costly.
Lastly, you’ll want to make sure that any rental property you buy gives you the cash flow you’re looking for and a desirable ROI. Check out this article to learn how to calculate ROI on rental property.
Now that you’ve determined that you’re comfortable being a landlord and the details about the location and type of rental property you want, it’s time to talk about the process of buying a rental property. As discussed above, you can either buy the property in cash or with financing.
If you’ve purchased a primary residence with a mortgage, you’ll notice that the process is very similar when it comes to buying a rental property. However, lenders do typically charge higher interest rates and ask for a higher down payment than they do for a primary residence. This is because of the higher rates of default on rental property loans and the fact that there is no mortgage insurance for rentals, respectively.
The underwriting standards for buying a rental property are generally more strict than for buying a rental property. For example, the DTI thresholds and credit score standards are more stringent for rentals. The lender also might want to see that you’ve had experience as a landlord before and take a closer look at your income and employment history.
Lenders each have their own criteria for whether or not they will approve a loan for a rental property. In general, though, some of the qualifications that might be required include:
Just like with getting a residential mortgage, it’s a good idea to shop around for lenders. You might find that some are willing to offer you more favorable terms than others.
If you buy a rental property with cash, you’ll be able to benefit from a much quicker purchase and closing process in most instances. Usually, you can have the closing right after the inspection. In hot real estate markets, offering cash can also make your offer more appealing to sellers. You also can save quite a bit of money when it comes to closing costs, and ultimately pay a lot less for the property over the life of the loan.
To buy a house with cash, the first step is to have your offer accepted by the sellers. You’ll then sign the Purchase and Sale Agreement in order to go under contract on the property. Your buyer will then usually ask for earnest money upfront as well as requesting proof of funds in the form of investment statements or bank statements. If you are using a real estate agent, they can help you navigate this process.
The next step is hiring title and escrow companies. Whether this is the responsibility of the buyer or the seller depends on the state that you’re in. So long as everything comes up clean in terms of the title, you can move forward to the next part of the process.
If you submitted your offer with an inspection contingency, which is usually advised, you’ll then have the home inspection and the opportunity to renegotiate or request repairs. It is usually the buyer's responsibility to pay for the inspection.
Finally, it’s time to review and sign the closing documents. The closing might be held at the office of the escrow company, title company, or a real estate attorney depending on the state you are on. Once the documents have been signed and the funds have been transferred, you’re now the proud owner of your first rental property!
Now that you’ve got the keys in your hand, it’s time to start being a landlord. It’s a good idea to consider the pros and cons of hiring a property management company from the get-go, and determine when (if ever) you will transition to having a management company deal with the ins and outs of your rental.
If you inherited tenants as a part of the deal, you’ll want to understand the rights that they have to ensure you don’t begin your career as a landlord by breaking the law. The type of lease the previous landlord had with the tenant will determine whether or not the tenant has the right to stay in the property for a given amount of time.
Basically, tenants with a fixed-term lease generally have the right to stay in the rental home until the lease expires. However, you don’t have to renew the lease once the period is up.
For tenants with a month-to-month lease, you typically only need to give them thirty days' notice if you’d like to replace them with new tenants.
Remember, though, that laws can vary between states. You’ll therefore want to consult the laws in your state and municipality before deciding what to do about inherited tenants.
If you buy the property empty, you can do any repairs you want to do and then start filling your vacancies. If you aren’t sure how much to charge for rent, you’ll want to look at comparable properties in your area to make sure you price it right.
In order to manage your rental in the most efficient way possible, consider setting up streamlined systems for all of your responsibilities. Create a clear and easy way for your tenants to pay rent rather than knocking on their door once a month, and let them know how to request repairs or contact you with questions or concerns they have. Communication is key for landlord-tenant relationships, so setting up easy ways to communicate with each other can make the whole process a lot smoother. You’ll also want to build relationships with local handymen and tradesmen that you can call upon for repairs if you aren’t doing them yourself.
At the end of the day, no rental property is worth buying if the numbers simply don’t add up. While there are a lot of subjective factors to what makes a good rental, you ultimately want to make sure that you're putting your money in the right place versus your other options. You can use this rental property calculator to make sure that the property you’re looking at will meet your financial needs.
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