3 Simple Things to Know Before Buying Your First Investment Property

Investing in real estate can be an excellent way to generate income and build wealth, but make sure you know what you're getting into first.

Feb 2, 2014 at 10:00AM

Housers

Source:  401(K) 2013.

Buying an investment property can have many rewards in both the long- and short-term, but there are certain things to consider before diving in. Doing your homework and planning your first investment purchase thoroughly can make the difference between a money pit and a retirement plan. 

Condition of the property
One of the most important considerations is the condition and future maintenance requirements of the prospective investment property, especially if the property has been a rental for some time. Tenants are generally not the best at taking care of property that isn't "theirs," and it is not uncommon for landlords to put off maintenance issues (such as replacing a leaky roof instead of continually patching it) in order to squeeze some extra money out of their property. 

Slater

Make sure all of the major parts of the property are in good working condition and are not overdue for a replacement, or else factor those costs into the purchase price. Frequent trouble areas include the roof, HVAC systems, electrical issues, plumbing, and anything that appears to have been a "do-it-yourself" job by the previous owner.

Dealing with tenants
Even though it will eat into your profits a bit, first-timers should hire a property management company to find tenants and deal with minor repairs. A good property manager will cost you about 10% of the rent you collect and is well worth the expense. 

The property manager will screen tenants, draft a solid lease agreement, hold security deposits, and deal with the legalities of evicting bad tenants. Trust me; you do not want to get involved in the eviction process unless you really know what you're doing.

A property manager may require or recommend you keep a portion (say 5%) of the rent in a fund for repairs. You don't want tenants calling you at home when their toilet is clogged at 3 o'clock in the morning. Most property management companies have handymen on standby for these types of issues, and generally can get things done for a reasonable cost.

Financing and returns
If you can afford to buy the investment property outright, consider how it will impact your returns. Let's say you buy a $100,000 home that you rent out for $1,000 per month. A typical monthly payment (mortgage + taxes + insurance) on a $100,000 property is around $600 at the current interest rates, and could be higher or lower depending on property taxes and insurance premiums in your area.

Moneyyy

Source: 401(K) 2012.

If you buy the place in cash, all you have to pay is taxes and insurance, leaving you with monthly income of around $670 (based on U.S. average insurance and tax rates), assuming 10% for a property manager and 5% in a maintenance fund. This translates to $8,040 per year, or an 8% annual return on your original investment.

If you finance with 20% down, you can expect cash flow of $250 per month after expenses, or $3,000 per year, a 15% annual return on your initial investment of $20,000. So, in theory, you could take that $100,000 and finance five rental properties and earn a 15% annual return on your money.

Bear in mind, investment properties are not as easy as primary homes to finance, and generally require at least 20% down and excellent credit in order to qualify, as well as several other assets in your name as collateral.

Foolish final thoughts
There is no one right way to buy and manage an investment property, and these are just suggestions about how to start.

Whatever you do, never skimp on repairs. It's not worth leaving yourself in a position to be on the hook for a small fortune if, say, a poorly maintained roof caves in while you have tenants living in the home. Before you get involved with investment real estate, do your due diligence and know exactly what you're getting into.

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