Rental real estate has high barriers to entry. Most people know someone who owns a few rentals and may even have a rich aunt or uncle who has a little real estate empire going. But it's hard to envision yourself getting into that world.
My wife and I are doing it by living in each rental for a few years before we lease it out. This helps us with easier financing, gives us time to learn all the little things we need to know about the properties, and helps ensure we aren't getting too big for our britches with purchases that we can't afford.
Let's go over each of these three factors.
Image source: Getty Images.
1. Obtaining better financing
The main reason to live in the house first is the financing. There are exceptions, but for most people bank financing for your first rental property will require a 25% down payment, an interest rate 2% higher than a conventional mortgage, a 20-year term, and a rent roll showing that the property produces enough cash flow to service the debt. If you buy the house as a residence, you may be able to do it with 5% down, a 30-year term, a 3% interest rate, and on your own financial background.
The plan would be to move into the house, making the normal mortgage payments while saving for the next house. This will probably take a few years, which is fine because when you finance a house as a residence, you need to live in it for a period of time.
Once you move, the lower payments on a conventional mortgage will make it easier to cover the debt with rents, but you may eventually want to form an LLC. Over time, you'll develop a portfolio of former residences that are now rented out. If you transfer the properties into an LLC and refinance with a commercial loan, it will be easier to access the equity going forward, and you can ditch the monthly mortgage insurance premium.
2. Gaining more local knowledge
It's hard to get local knowledge when you're a completely passive real estate investor. Note that by local knowledge, I don't just mean knowledge of the geography where the house is located but also the little things that you can only learn by living somewhere.
One of the houses my wife and I lived in for a few years had a dead sprinkler zone, a leak in a window well, hidden cat scratches, a defective ice maker, and a wasp problem in the backyard. We were able to find and easily take care of each of these issues over time.
You don't want to be embarrassed by little things like this cropping up during a showing, and you definitely don't want to be hit with a ton of repairs right after a tenant moves in -- that's sure to start the relationship off badly. Some of these problems would've come up in a normal inspection when buying the house, but there's always something the inspector misses.
It also helps with the repair costs. If you know there's a trick to lighting the pilot light or to unlocking the shed door, you can just teach it to the tenant. If you don't even know the problem exists, it means an expensive call out to a handyman or time that you personally have to spend trying to fix it.
3. Getting your feet wet slowly
Real estate investing is a ton of work. Until you have a good system going or a property manager, you're not only constrained by capital but by your own time. It takes time to research what you should charge for rent, show the property, screen tenants, do repairs, listen to complaints, and account for everything.
Living in your first potential rental gives you the time to start setting aside cash to be used as reserves as well as time to prepare to rent the house. Once you move and rent it, you can then spend the next few years gathering more resources to rent again. Eventually, you'll get to the point where you have a seamless process and it's easy to take on new properties, but until then, you don't want to burn yourself out.
Be conservative -- especially in the beginning
Long-term rental-focused real estate investing is great for building wealth and passive income. But it isn't without risk. Each property that you purchase will have substantial debt, and there is always the potential of long-term vacancy that forces you to make payments on you own.
Living in your rentals before you rent them, especially at the beginning of your real estate investing journey, is a way to slow down and invest conservatively. It allows you to move the house into your circle of competence, and it provides the best financing options. Eventually, you'll develop the expertise and capital to buy rentals and not live in them, but you should consider living in them when you're just starting out.
