In one form or another, real estate is an asset class that belongs in every serious investor’s portfolio to provide diversification and reduce overall portfolio risk. One of the ways to accomplish this is to invest in rental properties for monthly cash flow. Buying an investment property is very different than buying shares of a real estate investment trust (REIT). Success as a real estate investor requires a level of active participation and sufficient know-how ...
What type of investment property should you buy?
There are three primary types of residential investment properties with different property ownership responsibilities that can make a good rental for real estate investors:
- Condos, where you own the space and everything contained within the walls of your unit. The condo association takes care of common area maintenance, such as landscaping, shared amenities, and large structural items like the roof.
- Townhomes and duplexes, in which you own the property and surrounding land, but there is typically a shared component such as common grounds and amenities managed by a homeowner’s association (HOA).
- Single-family homes, which typically represent more of a maintenance responsibility. In addition to the structure, you may owe front-fees for water and sewer hookups, and you’ll likely have more land to care for. Many single-family homes are in a neighborhood with an HOA that manages common grounds and might restrict your ability to make changes to your property.
Based on its condition, a specific investment property will fall into one of these four broad categories with respect to the extent of the repairs and renovations required to get it "rent-ready":
Level #1: Turnkey -- No work needed.
Level #2: "Paint and carpet" -- Requires a deep cleaning and minor cosmetic work such as repainting the walls and updating worn-out flooring.
Level #3: Minor renovation -- Requires system upgrades that will involve licensed professionals such as a plumber and electrician. This type of home might need a new roof, new HVAC, and/or other major system, as well as paint and carpet.
Level #4: Extensive renovation -- Requires major work that’s going to need contractors to pull building permits. County inspections will likely be required as the repairs are being done. This level might include gutting the property before rebuilding and/or performing extensive structural repairs.
If you’re not handy -- or don’t have the desire or time to manage contractors -- a turnkey property may be your best choice. A "paint and carpet" renovation is also fairly easy to manage and improvements can typically be turned around quickly to get your rental tenanted. Homes that are distressed, such as a foreclosure or short sale, typically require more knowledge, experience and time to get rent-ready.
The property type and condition that fits you will depend on your risk tolerance, available cash, investment strategy, your network of tradespeople, and personal capabilities. Of course, home prices vary based on the condition and you’ll get a bigger discount when you buy a property that needs work. I recommend you start small and see if this is an investing strategy you like before you buy a property that needs a significant amount of work. My first property was a two-bedroom, two-bath condo that needed a deep clean, some touch-up paint and new carpeting.
How much money do you need to buy an investment property?
Traditional mortgage lenders such as banks, credit unions, and other financial institutions save the best terms and interest rates for homeowners who will personally occupy the property. (Unless you’re house-hacking, a rental property is not going to be your primary residence.)
Most of the time, investment properties won’t qualify for the minimum down payment of 3.5% that FHA loans offer. Real estate investors need to purchase a property using a conventional loan and put 20% down. The upside of buying an investment property with a conventional loan is that you don’t need to pay private mortgage insurance (PMI), which is a mandatory requirement of FHA financing and could cost you up to $83.33 per month for every $100,000 you borrow.
In addition to your 20% down payment, you’ll need to have enough cash on hand to cover closing costs and to pre-fund the escrow required by your lender. Closing costs vary by state, lender, loan amount, and loan type, typically ranging between 3% to 5% of the home’s purchase price.
So to buy an investment property as a rental, you need ample cash to pay 20% down and 5% in closing costs. And if you’re not buying a turnkey property, you’ll need cash for the repairs to get the home rental-ready.
10 things to research before making an offer on an investment property
1. Monthly cash flow -- The most important aspect of buying an investment property is making sure the numbers work -- that the property will generate a positive monthly cash flow. For example, let’s say you purchased a property for $100,000 and your monthly budget looks like this:
- Mortgage payment (which includes taxes and insurance) is $680
- Vacancy allowance is $100
- Property management is $120
- HOA fee is $65
Let’s assume the monthly rent in this example is $1,200. These expenses total $965, so your property cash flows $235 per month. While that may not sound like much, consider that you put down $20,000 (and took out a conventional loan for $80,000 to purchase this $100,000 home). You’re getting an annual return of about 14% on your down payment of $20,000. The math looks like this: $235 x 12 = $2,820. $2,280 divided by $20,000 = 14.1%. (Of course, you’ll have to pay closing costs which typically run 5% the year you purchase the property, so you’ll only make 3.6% on your $20,000 year one.) Before buying an investment property, you need to determine whether you're making a good investment.
Many real estate investors use hard money loans (funding provided by private lenders, as opposed to government-regulated financial institutions) to allow them to purchase investment properties quickly and then refinance into a conventional loan. Be sure you shop around to get the best interest rates and loan terms no matter what financing you decide to secure.
3. Property taxes -- Property taxes are set by county governments and can vary widely in the same state. Cities typically have higher taxes than suburbs, but that’s not a hard-and-fast rule. Before you buy, check the tax rates and calculate what the property tax expenses would be.
4. Property insurance -- This, too, varies by location and type of property. Typically, the rates are higher on condos than single-family homes, and a property located in a high-crime-rate area or in a flood zone will cost more to insure. The difference can be substantial, so get an insurance estimate before you make an offer on an investment property.
5. HOA and condo rules and regulations -- You must determine if there’s a managing authority and what the rules are when it comes to renting and property improvements. My last investment was flipping a townhouse in an HOA community. The listing description touted that it "would make a great rental or flip," but that was inaccurate. The community HOA doesn’t allow rentals; all properties must be owner-occupied. Luckily, I did my homework before making an offer and made sure the numbers supported this property as a flip opportunity.
6. Title companies -- Like lenders, you have your choice of closing companies. Some are better than others and not all charge the same fees. There are title companies with experience dealing with real estate investors. The difference can easily be a savings of $1,000, so be sure to shop around for your title company.
7. Structural integrity of the property -- Always get an inspection! While it’s not a fail-safe that an inspector will catch everything, this is a not-to-be-missed step regardless of the visual condition of the property. Structural issues, like a long crack in the foundation, are too expensive to leave to chance.
8. Rental rates and location stats -- Dig deep to ensure the property will deliver the monthly rent you need. Estimate a range your property will rent for by looking at similar properties, or comps, on websites listing local rental rates. If you’re working with an agent, have them do an analysis of active, pending, and closed rentals within a three- to five-mile radius of your property. Real estate investing is local; renters care about the neighborhood, their commute time, the schools, the property condition, crime stats, and more, and a combination of these aspects will affect the rent your particular property will support.
9. Existence of a pool of qualified tenants -- A bad tenant will cost you money, leave you aggravated, and waste a lot of your time. Be sure your investment property is located in an area where there’s a large pool of qualified tenants. Do an extensive background check on any applicants, including credit score, pay-stub analysis, employment verification, criminal and civil records, previous rental history, and even a visit to their current home to see how well they take care of their residence. Actions speak louder than words and your property is an investment that needs to generate income. Be sure to price your rental at fair market rates to ensure you get a decent number of qualified tenants to choose from.
10. Property management -- If you’re not planning to find, screen, and manage tenants or perform property maintenance yourself, you need to find a property manager and factor the cost into your numbers. Typically, property managers charge one month’s rent to place tenants and 6% to 10% of your monthly rental income to manage the property for you. Ask fellow investors for recommendations and do your due diligence. The importance of efficient and reasonably priced property management is second to screening tenants when it comes to managing a profitable rental property long-term.
Ready to make an offer to purchase your investment property?
Buying a house is a big decision. Choosing and purchasing an investment property is no exception. Not only does buying a rental property require a large outlay of cash and financing commitment, it’s a long-term investment with high transaction costs when you buy or sell. The strategy involves buying an income-producing asset that’s in a fixed location subject to local market conditions. Making an informed decision by doing proper due diligence on many aspects is key.
Don’t journey the path to ownership alone. Use the services of a real estate agent to help you find, evaluate, and acquire market properties listed for sale on the MLS. You get the expertise of a market specialist and representation of a licensed professional absolutely free. Typically, commission for both the buyer’s agent and the listing or seller’s agent is paid out of the seller proceeds, even though a buyer’s agent represents you and your best interests in the transaction.
For off-market properties, your agent will likely not receive a commission from the seller (so you should consider paying a small research and consultation fee). However, I highly recommend consulting with an "investor-friendly," knowledgeable agent before submitting an offer on any investment property. You need to know if the current market value and After Repair Value (ARV), two numbers an agent can research for you, support monthly cash flow requirements and long-term investment goals. And don’t skip the home inspection on off-market properties.
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