How to Get Started Investing in Rental Properties

How to Get Started Investing in Rental Properties

Decide If Youre Cut Out to Be a Landlord

Being a landlord can be a good way to earn real estate income, but it’s not easy or glamorous. In addition to choosing the right property, prepping the unit, and finding reliable tenants, there are always maintenance hassles and headaches.

Do you know your way around a toolbox? How are you at repairing drywall or unclogging a toilet? Sure, you could call somebody to do it for you or you could hire a property manager, but that will eat into your profits. Property owners who have one or two homes often do their own repairs to save money.

Of course, that changes as you add more properties to your portfolio. Lawrence Pereira, president of King Harbor Wealth Management in Redondo Beach, Calif., lives on the West Coast but owns properties on the East Coast. As someone who says he’s not at all handy, he makes it work. How? “I put together a solid team of cleaners, handymen, and contractors,” says Pereira.

If you're not the handy type and don't have much spare cash, being a landlord may not be right for you.

When to Hire a Property Manager

Rental property owners can manage the property themselves or hire a property manager. It can be a hard decision to make because property managers typically charge between 8% and 12% of collected rents, which can really eat into profits.

Still, hiring an experienced property manager can be well worth the cost. After all, it means less work and fewer headaches for you, as you take advantage of their industry expertise. In general, a property manager will:

  • Know how to market the property
  • Understand the local rental market and ensure you price the rental accordingly
  • Show the property to potential tenants (so you don't have to)
  • Screen tenants (for example, conduct credit checks and verify references)
  • Collect rent on your behalf and deposit the money into your bank account
  • Handle late rents and navigate the eviction process
  • Handle tenant complaints
  • Arrange maintenance and repair work
  • Pay property-related bills, such as property taxes, utilities, and insurance

To decide if hiring a property manager makes financial sense for you, ask yourself these questions:

  • Do I have time to manage the property myself? If you have another full-time job, you likely won’t have the time or energy to manage a property on your own. This is especially true if you own multiple properties.
  • How close is the rental property to my home? Being far away from the rental takes more time out of your day and makes it more difficult to manage routine and urgent issues.
  • Am I willing to deal with tenants? Even if you do a good job of screening, it’s likely you’ll have to deal with unreasonable tenants, late rents, and evictions at some point. Is that something you’re willing to do?
  • Is my rental property for short-term or long-term tenants? It might be easier to self-manage if you are looking for long-term renters. But if it’s a short-term rental (for example, an Airbnb), you will be dealing with many different tenants—and potentially a lot of complaints and maintenance issues.
  • Do you need to be in control? If you will have a hard time handing over responsibilities such as choosing tenants and performing maintenance tasks, you may be better off managing the property yourself.

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Do you have to manage rentals yourself?

A lot of people think landlords are constantly unclogging toilets in the middle of the night. The truth is I have never unclogged a toilet in one of my rentals. I have never done any manual labor in one of my rentals. I have always had contractors, plumbers, or other professionals do that work. I did manage my rentals until I had seven (to be honest, my wife managed them, but I liked to take credit).

It was not difficult to manage the properties, but it did take time. After I had seven rentals, we realized that I was better off using my time to do other things besides finding tenants, collect rent, and oversee the properties. When I hired a property manager, it was awesome. I had someone to take all the calls, rent the properties, and unclog those toilets…or at least call someone else and tell them to unclog the toilet. I have not been some of my rentals for years!

You do not have to manage the properties yourself, and for many people, you should not manage them yourself. You need to be tough and strict with tenants to make sure they are paying rent and to make sure you are not buying into sob stories. I was not tough when I managed my rentals, and I think I made more money with a property manager because they were tough and collected more money and as chose better tenants.

If you decide to manage the properties on your own, make sure you know what you are doing. Advertise the rentals well, know what the right rent to charge is, take your time screening tenants, verify references, and be strict with late fees and inspecting the property on a regular basis

A lot of people get burned out with rentals because they manage them themselves. A good rental should make money even with property management costs.

My best-selling book Build a Rental Property Empire goes over everything in this guide and much much more! You can get it at Amazon as a paperback, ebook, and audiobook!

9. Know Legal Obligations

Landlords are held to strict legal obligations. In addition to the leases their tenants sign, each state will levy their own laws, to protect both landlords and tenants. That said, it pays to know the laws you must abide by when acting as a landlord. Nothing will derail a successful real estate investment faster than ignorance of the law. Before buying a home, make sure you know exactly what you are getting into and the steps you can take to mitigate risk.

6. Make Sure You’re Insured

This insurance covers the house itself, other struA homeowner insurance for rental properties is sometimes called “landlord insurance” and is also known as a “dwelling fire policy” or “fire and special perils policy.” Homeowner insurance covers your house if it burns down or there’s a break-in. And it pays medical and legal bills if someone gets hurt on your property. When you rent out a home, there’s a higher risk of loss to you and your insurer.

This insurance covers the house itself, other structures on the property (such as a garage or shed), the owner’s (not the tenant’s) possessions, lost rental income if the house is damaged and uninhabitable, and some liability protection for the owner in case of an injury or lawsuit. Read the fine print and all the exclusions.

Landlord insurance is a more expensive must-have that helps protect you, your property, and your tenant. If you have a mortgage, your lender will demand you carry it.

What education do you need?

Education is a key component of investing in rental properties, but it is not the only part. In order to invest quickly, you have to take action, not just educate yourself. While you are learning about rental properties, there are many things you can do to speed up the buying process.

  • Talk to a lender as soon as you can. If you have a credit or qualifying problem they can help you get that solved. The sooner you talk to them the better.
  • Start looking at houses in your market area with a real estate agent.
  • Start locating contractors and insurance agents.
  • Start looking for portfolio lenders.
  • Start attending REIA meetings.

Not only does performing these tasks get you involved in real estate, many times these contacts can help you learn about rental properties as well. Local contacts like real estate agents and lenders can educate you about local customs and local markets.

Figure out the money

Get preapproved for financing

For your first deal, use a bank or local lender to finance your real estate deal.

They typically require 20% down for a rental property. If you buy a property with multiple units, say a duplex, triplex, or fourplex, and you live in one of the units for a year, you can get a down payment as low as 3%. If you’re qualified to get a VA loan or USDA loan, it could be 0%. Talk with some local lenders to find out what programs they have and what you qualify for. Note that this same method may not work for buying family homes.

If you don’t have enough money to put down, you can try networking with other real estate investors in your area. You might be able to partner with someone on your first deal in that you bring the deal and they bring the down payment. Obviously, that’s a bit trickier to work out than putting down your own money.

When it comes to owning an investment property, your budget involves more than how large a mortgage you can afford. In addition to considering monthly mortgage payments, you also need to keep in mind the ongoing costs of owning and renting out the property—utilities, maintenance and upkeep, taxes, and more. You then need to weigh those costs against how much you realistically expect to collect in rent from your target tenant.

Do a search for comparable rental properties in the areas you’re considering, taking into account the size of the properties and the neighborhoods you’re looking at. This will give you a better feel for average rental prices. You can use some of the BiggerPockets calculators to calculate the cap rate, cash-on-cash return, and other factors.

Or, find another investor

This may seem like a hard step, but it can be easier than you think. If you’re telling people about your goals in real estate, it makes sense that they’ll ask you about it. Remember that real estate is a numbers game, and you never know when you will be talking about investing in front of the right person.

Many first-time investors fund properties with private money—that means finding another investor willing to front the money and earn a decent return on their investment.

This is also why it is so important to be educated, committed, and have a strategy. You need to know what you’re talking about and have a plan that people can see will work.

Investors have their own language. It includes terms like “ROI,” “cash-on-cash,” “principal” and “debt service.” You’ll have less trouble finding an investor after you learn the language and speak it.

Some people believe that good deals find money, which is why it’s suggested that you get a deal under contract prior to finding an investor, and not vice versa.

At some point, an investor will want to know how much money they can expect to make. Some investors will talk in terms of capitalization rates, although some will want to know what their cash-on-cash is first.

A cap rate is calculated by dividing the net operating income (NOI) by the all-in price. For example, if the net operating income is $6,100 and the all-in price is $110,000, your cap rate would be about 5.5%.

Be conservative in your numbers. Investors will want to know how much you are allotting for vacancy, maintenance, and other expenses. Don’t oversell a deal. It’s far better to under-promise and over-deliver; it’ll make your life easier and help you build long-term relationships with investors.

Analyze deals

It may be complicated at first, but you need to start analyzing potential properties, and a lot of them, so you get comfortable with deal analysis. Analyze a few deals every day until you find something you think is right for you.

It’s recommended that you buy 10% to 20% below market. This will allow you to increase your net worth and thus your financial security. If an emergency were to force you to sell your property, you’ll have leeway to decrease your asking price and get through the selling process faster.

Keep in mind there are other aspects to pay attention to when you’re looking for a property. For example, your return on investment, or ROI, should be at least 15%. To determine this figure, use the following formula:

ROI = rent – debt and expenses

Additionally, it’s good to know that rent should be at least 1% of the purchase price. That means if you bought a property for $200,000, the rent should be at least $2,000.

8. Weigh the Risks and Rewards

weigh the risks and rewards of rental property invOwning rental properties is a long-term investment. Transaction costs are high, and real property is an illiquid asset that you can’t sell quickly if you need cash. So, make sure you do your due diligence and weigh the risks and rewards of rental property investing.

Rewards

  • Huge tax benefits including taking depreciation on an asset that is likely appreciating
  • Collect monthly rental income
  • Provides portfolio diversification (real estate is not correlated to stock market fluctuations)
  • High potential for asset appreciation
  • Tenants pay off your mortgage, providing you with equity at no cost to you

Risks

  • Potential for negative cash flow due to bad tenants or a high vacancy rate
  • You take on landlord responsibilities
  • Your property value is subject to housing market fluctuations
  • You could lose money by underestimating expenses or overestimating rent
  • You can’t sell quickly if you need emergency cash

Getting Started

While there are many variables to consider when purchasing your first investment property, you should start by doing your research. Look at housing prices and neighborhoods and begin saving for a down payment. And when you’re ready to dive head first into the real estate game, you can start by getting preapproved for a mortgage.

What kind of insurance do you need?

Since a rental property is for investment and not personal occupancy, standard homeowner’s insurance policies will be inadequate.

As a landlord, there are certain risks you’ll face in having tenants living in your property. For example, if a tenant – or one of their guests – is injured on your property, you may be held liable.

  1. Regular Insurance For a Rental Property – you can generally purchase a rental property policy through the same insurance companies that offer standard homeowner’s insurance plans. But you’ll need to alert the insurance company that it’s a rental property and expect to pay a higher premium for the coverage.
  2. Extra Liability Insurance – you may need more than the standard amount of liability insurance provided by a typical homeowner’s insurance policy. And though it’s not required, getting an umbrella policy is an outstanding idea. An umbrella policy is a general liability policy that will provide coverage over and above the liability offered by your homeowner’s insurance policy. Fortunately, it’s pretty inexpensive coverage, but it will be extremely valuable in a high dollar value lawsuit situation.
  3. Loss of Income Rider – another provision you should seriously consider adding is a loss of income rider. It won’t cover periods of time when the property is vacant, but it will replace the rental income if the property is damaged or destroyed, and therefore not capable of producing rental income.

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What do you need to start?

I’ve already covered the necessity of educating yourself about real estate investing. That includes taking courses, getting to know other real estate investors, and reading books on the subject. Even more important, is market knowledge. The market is what you are truly investing in, and you’ll need to know it well before you take the plunge. Make sure you can comfortably check the boxes on all the steps before making an offer on your first property.

Once you can, you’ll need the following to go live with rental property investing.

Cash to close

If knowledge is critical to success in investing in rental properties, having sufficient cash is a close second.

Here’s a reality you need to be aware of from the start: you will not be able to purchase investment real estate with 5% down, 3% down, or with the 100% financing offered by the Veterans Administration. Those no- and low-down-payment financing deals are only available to owner-occupants. (The exception will be if you purchase a two-to-four family home, live in one of the units, and rent out the others).

For most investment properties, you should expect to make a down payment equal to at least 20% of the purchase price. This is a typical requirement of traditional mortgage lenders.

That means if you’re purchasing a home for $250,000, you must be prepared to make a down payment of at least $50,000.

Closing costs, escrows, repairs, and cash reserves

There will also be closing costs and escrows for real estate taxes and homeowner’s insurance. Expect that those will add another 4% to 5% of the purchase price to your down payment. The recommended option is to get the seller to pay the closing costs for you, which they may do in exchange for a slightly higher sale price.

I’ve also already mentioned having cash reserves equal to six months of house payments on the property, and this is also typically a requirement of traditional mortgage lenders. But you may also need to factor in additional cash to cover any expected repairs, which will almost certainly be the case if you’re purchasing the property for less than its true market value.

Get a home inspection from a qualified home inspector

The mention of repair costs is the perfect time to discuss the absolute necessity of a home inspection. Even if you know a good bit about investing in real estate, knowledge of the integrity of the physical structure of the property is its own specialization. It’s best to get a set of trained eyes into the property to see what’s lurking in places most buyers don’t look.

For example, you may look at a wall and see what looks to be a minor crack. But a home inspector might see that as a tipoff of bigger problems, like water damage or termites. The same thing can happen with a sagging ceiling. Certified home inspectors are trained to see problems that aren’t obvious. You should have any property you want to purchase thoroughly inspected from top to bottom.

Pay careful attention to the inspector’s report – it can both reveal hidden problems and give you bargaining chips to renegotiate the price to a level that will accommodate the needed repairs.

Or, since you’re buying the house for rental purposes, you can use the report to have the current owner remedy the problem before closing. That will make the house easier to rent once you close.

Line up your financing in advance

Unless you’re in a position to pay the full price of a rental property in cash, you’ll need to obtain financing to make the purchase. Since you’ll need to purchase a rental property for less than its actual market value, you’ll need to be a fully qualified buyer, ready to close in the shortest time frame possible. That means having both your down payment and your financing ready to roll.

Obviously, you can’t get a mortgage before you select a property. But you can get a pre-approval. That involves filling out an application for mortgage financing and securing approval based on your credit and income. Once you have your pre-approval, you’ll be able to make an offer and close quickly.

Your pre-approval should be confirmed by a written letter from the lender. It will not only indicate that you’re fully approved, but also the amount the lender will provide. A pre-approval letter is one of the strongest negotiating tools in any real estate transaction. It reassures an anxious seller that you’re fully qualified to close on the deal.

It’s possible to get a quick pre-approval and closing through online mortgage providers. One prominent example is Reali Loans. They offer an all-online application process, charge no origination fees – saving you between 0.5% and 1% on closing costs – and can close your loan within 30 days. 

Applying for a mortgage on an investment property is easy. All you need to do is visit the site, fill out an application, get your pre-approval letter, and then begin shopping for your first rental property.

Risks and rewards of investing in real estate

Of course, all investments carry risks. And investing in real estate is no exception. A recession or depression may see tenants in financial trouble and unable to pay their rent. And there are times when home prices fall, though rarely for long, as this graph from the Federal Reserve Bank of St. Louis shows:

Source: Federal Reserve Bank of St. Louis

Source: Federal Reserve Bank of St. Louis

If you’d bought a home at the median price nationwide in the depths of the last dip (February 2012), you’d have more than doubled your money over the next decade. And that’s just in home price appreciation. The profits you’d have received as rent on an investment property or vacation home would be on top of that.

Know your market

But be aware that those are nationwide averages. Just as there are many hot spots where home price appreciation is much higher than across the country, there are plenty of cold spots where prices have been stagnant or have barely moved. Indeed, in some places, home prices have fallen.

That’s why one of the golden rules of investing in real estate is “location, location, location.”

Research the property market where you’re buying and make sure you thoroughly understand its dynamics. You certainly need to understand the market for homebuyers and sellers. But, if you plan to rent the property out, you must also fully grasp the rental market.

Summary

Buying first rental property assets is a big step on the way to operating a cash flowing rental portfolio. With several properties producing rental income, investors may collect rent passively, but it all starts with buying your first rental property. However, it is important to note that the first rental property will set the tone for how things proceed. In order to realize success, start out on the right foot with these tips, and make your first rental property your best investment decision ever.

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