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Buying an investment property can be a great way to generate income and build wealth over time, but getting started can be intimidating.
When we use the phrase "investment property," we're referring to a property that you plan to buy and rent out for the purpose of generating income. If you're thinking about fixing and flipping a house, that's another topic.
With that in mind, following certain steps can help make the process of buying your first investment property as smooth and productive as possible. All of these steps might not apply to you (for example, if you're planning to pay cash, you can skip the financing discussion), but here's a general overview of the process, followed by a detailed discussion of each step.
- Decide whether an investment property is the best way to invest in real estate.
- Assemble your team.
- Decide what (and where) you want to buy.
- Secure financing for the property.
- Learn how to calculate cash flow the right way.
- Decide on a property to buy.
- Decide whether you want to hire a property manager.
Decide whether an investment property is the best way to invest in real estate
Buying an investment property isn't right for everyone, and it isn't the only way to invest in real estate. So, before you start looking for your first investment property, take a step back and decide if it's the right way for you to get into the exciting world of real estate investing.
On the positive side, investing in rental properties is a great way to get both income and long-term appreciation, and thanks to the relatively easy (and safe) use of leverage, investment properties can produce remarkable returns.
But there are a few things to consider:
- Time commitment: Even if you decide to hire a property manager (more on that later), owning investment properties can be an active, time-consuming way to invest in real estate.
- Liquidity: Investment properties aren't a liquid investment. If you want to receive fair market value for your rental properties, they can easily take months to sell.
- Capital requirement: Unlike some other forms of real estate investment, you will need a significant amount of money to buy an investment property. In most cases, you'll need a minimum of 20% down, closing costs, and several months' worth of reserves in the bank.
- Unpredictability: Although rental properties can provide you with great income, it isn't necessarily going to be steady income. Properties become vacant from time to time, and things break that you'll need to replace.
Here's the point: If you're okay with these four drawbacks, investment properties can be a smart choice for you. Otherwise, you may want to look elsewhere. For example, if you need liquidity or steady income, a real estate investment trust, or REIT, could be a good choice for you. If you want to invest in a single property but prefer a passive role, a crowdfunded real estate investment could be worth a look.
Assemble your team
As a new real estate investor, surrounding yourself with a top-notch group of professionals is extremely important. This starts with a local real estate agent who has extensive experience dealing with investors.
To put it mildly, the process of shopping for an investment property is very different from shopping for a primary home, so be sure whomever you choose knows what they're doing. You'll also need a good real estate attorney, insurance agent, home inspector, appraiser, and more, but your real estate agent is generally a great source for all of these professionals. You can read our guide to assembling your team for more details, but the bottom line is that real estate investors are only as good as the professionals in their corner.
Decide what (and where) you want to buy
Before you go any further in the process, it's a smart idea to define your investment goals.
For example, do you want a single-family home or a multi-unit property? Or is the low-maintenance nature of a condo more along the lines of what you're looking for? You can generally get more cash flow with a multifamily property, but single-family homes tend to have more equity appreciation potential, especially in hot real estate markets. (Note: Two- to four-unit properties are considered multifamily residential for financing purposes. Five units or more will likely require commercial financing and is rarely a good fit for first-time investors.)
It's also smart to narrow down a price point. As we will discuss in-depth in the next section, you should expect to need a minimum of 20% down for an investment property mortgage, and 25% down payments are more common. If you're planning to finance your investment property, it's wise to use this figure to set your budget. Remember that you'll also have to pay closing costs, and your lender will expect you to have at least six months' worth of payments in reserve.
Geographical location is important as well. You might want to focus your search in a specific neighborhood, or you might be flexible in this area. When searching for a rental property recently, I focused on one of the trendier neighborhoods in my city but limited my search to homes zoned for the highly-rated elementary school that serves the area. Millionacres has created an excellent guide to some of the things you might want to consider when choosing the right location to focus on in your investment property search, as well as compiled a list of the best places to buy a rental property in 2020.
Also, decide how much effort you're willing to put in. You can typically find the best value in properties that need some repairs, but this creates additional work for you. Or, you could decide to focus on rent-ready properties instead. There's no right or wrong answer here, but considering these issues can help you (and your real estate agent) when it comes time to search for a property.
Secure financing for the property
If you're planning to pay cash for your first investment property, you can skip this section. Otherwise, you'll have to figure out where the money is going to come from.
Financing an investment property can be very different from financing a primary home. You should expect to need excellent qualifications, as lenders typically consider investment property mortgages to be higher risk compared to loans on owner-occupied properties.
With that in mind, when it comes to investment property financing, you have a few different options. Whichever type you choose, it's a smart idea to have a preapproval for a loan or have otherwise secured a financing source before you start to look at properties. Here's what you need to know about your options before you get started:
Conventional financing is a broad term referring to a mortgage that you obtain from a bank and that is backed by your personal qualifications. This can refer to a conforming loan, which meets the lending standards for Fannie Mae or Freddie Mac, or another type of bank lending product, such as a jumbo loan.
The requirements for conventional financing of an investment property depend on factors such as the type of property (single-family versus multifamily), your credit score, employment, and assets, as well as your other debts. One important point to know is that while you may be able to use some of the property's expected rental income for qualification purposes, your current income is the main basis for qualification. If your existing mortgage or other debts consume a substantial amount of your gross income, you might find it difficult or impossible to obtain conventional financing for an investment property.
If you can qualify for a conventional loan, it's usually the most cost-effective way to go. Interest rates tend to be a bit higher than an owner-occupied home loan, but it's generally cheaper than the alternatives.
When it comes to long-term financing options for investment properties, asset-based loans are the main alternative to conventional mortgages.
As the name implies, the primary basis for loan qualification with an asset-based lender is the underlying asset itself -- in this case the investment property -- and not the borrower's personal qualifications. To clarify, an asset-based lender will still check your credit score and use this to determine eligibility and your interest rate, but your personal debts, income, and employment situation won't be considered. In fact, I obtained an asset-based loan for a triplex I purchased and the lender never even asked for a copy of my tax return, W-2s, or a pay stub.
The primary condition for approval is that the property generates sufficient cash flow to cover the mortgage payments with a reasonable cushion. Specifically, the lender uses a metric called the debt service coverage ratio, or DSCR.
Other financing options
In addition to conventional loans and asset-based mortgages, there are a few other ways to finance investment properties that you might want to consider. This isn't necessarily an exhaustive list of financing options, but it could give you some good ideas:
- Second home financing: Many lenders offer three types of financing -- primary residence, investment property, and second home. The short explanation is that second home financing might be available if you plan to occupy the home some of the year. So, if you plan on investing in a vacation rental, this might be an option. Second home financing typically has lower down payment requirements and easier qualifications than investment property mortgages.
- House-hacking: You can read our guide to house hacking for more details, but the short version is that if you buy a multiunit property and live in one of the units while renting out the others, you can consider the entire property to be a primary residence and can finance it as such. For example, you can buy up to a four-unit property and get an FHA loan with 3.5% down if your income and other qualifications justify the loan.
- Home equity: One common way to obtain easy financing for an investment property is to tap into the equity you've built in your primary home, through either a home equity loan or a home equity line of credit (HELOC).
- 401k loans: If your plan allows it, your 401k or other qualified retirement plan may allow you to take loans of as much as $50,000. While borrowing against your retirement savings isn't always a good idea, it can be a good source of low-cost financing for an investment property.
Learn how to calculate cash flow the right way
Cash flow is one of the most important concepts for new real estate investors to understand. You can get a seemingly great deal on an investment property, but if your costs of ownership are more than the rent it brings in, it will drain your bank account over time. So, it's essential that you determine whether a potential property will realistically generate positive cash flow from day one.
The key word here is realistically. It's not enough to simply subtract your monthly mortgage payment from your rental income and get a positive number. That just tells you that you'll have positive cash flow when things are going perfectly.
In the real world, your property will be vacant from time to time, and there will be maintenance items you'll have to pay for. Keep all this in mind when estimating cash flow.
Now, there's no bulletproof way to determine how much these expenses will be, but I generally set aside 15% of my rental income to cover vacancy and maintenance. So, a good cash flow calculation might look like this:
- Start with the property's expected monthly rental income.
- Subtract your mortgage payment, including taxes and insurance.
- Subtract your property manager's fee (if applicable).
- Subtract any other recurring expenses (e.g., pest control or lawn maintenance).
- Subtract your vacancy and maintenance allowance.
For example, let's say you want to acquire a duplex that will rent for $2,000 per month. Your expected mortgage payment will be $1,200, and your property manager charges 10% of collected rent. You don't pay any other property expenses and anticipate vacancies and maintenance will consume 15% of your rental income.
|Vacancy and maintenance allowance||$300|
One good rule of thumb that I've used in the past is the "100 times rent" rule. This says that if you multiply a property's expected rent by 100, it tells you the most you should pay for it. Now, this isn't a set-in-stone rule, but using it as a general guideline can be a great way of narrowing down your list to properties that should generate decent cash flow.
Decide on a property to buy
Now comes the fun part. Once you've decided what type of property you want to buy, know how you're going to pay for it, have a team in place, and know how to find cash-flowing rental properties, you're ready to start looking for properties.
It's a common rookie mistake to look at potential properties through a homeowner's eyes. In other words, I often hear things like "I hate that kitchen." While the property might not meet your tastes, you're looking for something that would be rentable -- not that you like. You're an investor. Things like the number of bedrooms, school district, and access to interstate highways are important. Focus on those, not on whether you like the home.
After you've identified a rental property that’s a good fit, it's time to make an offer and negotiate a purchase price. Your real estate agent can help guide you through this process, as well as help you navigate the time between having an accepted contract and closing on the property.
Decide whether you want to hire a property manager
One of the most important decisions you'll need to make with your first investment property is whether you want to become a landlord or not. You can either self-manage your property or pay a property management company to do it for you.
The major downside to hiring a property manager is the cost. Property managers typically charge between 8% and 10% of the collected rent. If your property's cash flow isn't huge, this can seriously cut into your profit margin.
However, it's important to consider what you get in exchange for your property management fee. Your property manager will:
- Use their experience to price your property appropriately so it collects the maximum amount of rent possible. This alone can justify the cost in many cases.
- Market your property to prospective tenants.
- Conduct background and credit checks on prospective tenants.
- Collect rent on your behalf.
- Deal with maintenance issues and tenant complaints.
- Pay bills on your behalf, such as any landlord-paid utilities.
In my opinion, a good property manager is easily worth 10% of the rent. If you have lots of time on your hands and want to save money by self-managing, by all means give it a try. However, I employ a property manager to handle the day-to-day operations of my own rental properties and strongly suggest you consider doing the same for your first rental property.
Learn from your mistakes
Finally, it's important to realize that you will make some mistakes the first time you buy an investment property. I certainly made some (check out my first-timer mistakes).
However, it's crucial that you learn from them. For example, I learned very quickly that 30 days isn't enough time to comfortably close on an asset-based loan, so now I write a 45-day escrow period into my offers.
The point is that nobody is a great rental property investor at their first try. Educating yourself as much as possible will put you in the best position to succeed, but there’s simply no substitute for real-world experience.
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