When considering investing in rental properties, it’s easy to imagine yourself as Scrooge McDuck, doing the breaststroke in your piles of gold coins. Buy a few rental properties, grab your floaties, and prepare to swim in your riches, right?
While real estate investing is absolutely a great path to financial freedom, it takes a slightly more strategic approach to find success. Rental properties can range from suburban single-family houses to multi-family buildings and everything in between. Even within those categories, there are many questions to answer before you are ready to buy property.
What to Buy
- Will you do better with a large luxury property or with smaller, older rentals that are more affordable for tenants?
- Should you look for a turnkey property ready for a tenant to move in today or something that needs some work?
Return on Investment
To choose the best investment property, you need to know the Return-On-Investment (ROI) for different types of rentals in your area. Calculate ROI by taking the total income from the investment, which will be the rents collected, and subtracting your expenses, including mortgage payments, HOA dues, property management fees, and repair expenses. Divide that by the initial expenses (downpayment, closing costs, renovations), and you will have your ROI.
The higher the ROI, the more money your invested dollars generate to help load that gold-filled swimming pool you are working toward. Are larger homes with luxe finishes seeing higher returns, or is it more mid-market properties that have the best profits?
Consider how much time and money you want to spend maintaining the property or dealing with service calls. Newer properties generally require less work, but they cost more up front.
Finally, look at how the type of property and price point may affect the frequency of late payments, evictions, and damage claims. In most cases, single-family homes will be best for a new investor as they tend to have the fewest issues with maintenance and tenants.
For many full-time investors, choosing which homes to purchase requires a significant amount of their time. Those decisions dictate how much money each property earns so it makes sense to spend time getting them right.
If this seems overwhelming, there are services to help you find ideal rentals. These real estate investment firms familiarize themselves with the rental market in a specific area and help investors choose the properties most likely to make the most money with the fewest headaches. They do the research so you can make the most informed decisions on what to purchase.
How to Buy
As with purchasing a primary residence, most people take out loans to buy rental properties. The process of obtaining financing for an investment property is similar, but loans for rentals typically have higher interest rates. They may also require higher credit scores, lower debt-to-income ratios, or higher minimum down payment percentages.
Despite these requirements, you may still want to finance even if you have cash available to pay for a property without a mortgage. If you spend all your money on the purchase, you have nothing left to cover emergencies. You may also eat away at your ability to buy your next rental, so consider whether holding back some cash and taking out a loan is the better option.
How to Manage
Managing the property yourself allows you to keep the most profit from your rental. That means you collect the rent, take calls from the tenants, advertise the property, screen tenants, and deal with any disputes. If you do this yourself, you don’t pay any management fees, but it can also be time-consuming.
If you aren’t prepared to take a phone call about an overflowing toilet at two o’clock in the morning, you may choose to hire a property manager. While they charge a fee–usually five to ten percent of the rent–they do all the day-to-day work of managing the rental. That makes the investment much more passive for you. They are also experts in local laws and tenant protections, so they will ensure you don’t run afoul of the legal system. Rental laws can be complicated. Having an expert offers some peace of mind.
Many people feel that hiring a property manager is worth the expense and can even allow them to own more rentals because each one takes less of their time. Others prefer to manage their rentals themselves, believing their time is worth the savings.
How Much to Save
In most cases, you will need 20-25% of the purchase price to use as a down payment and additional funds for closing costs.
You should also have enough money to cover whatever problems arise with the rental. Tenants move out, rent payments are sometimes late, roofs leak, and refrigerators fail. That leaking toilet we mentioned earlier? You need to be able to pay the plumber.
As a good rule of thumb, you should have three to six months’ expenses in an emergency fund. This should cover the mortgage, taxes, utilities, HOA, insurance, and some money for repairs.
As a novice real estate investor, you will need to determine what property, financing, and management options work best for your situation and goals, and make sure you are financially prepared for this new investment. Once those decisions are made, you are one step closer to swimming in the riches that investing in real estate can bring.