Baby’s first haircut, your kid’s first prom date, Junior’s first touchdown… Life is full of milestones. Now that you’ve decided to use investment real estate to improve your financial future, it’s time to buy your first rental property. Whether you are doing this to increase your monthly income, set yourself up for a faster retirement, or diversify your investments, you’ve made a great choice. Here are some tips to keep in mind as you start searching for that first rental.
Remember Why You Are Buying
If your idea of a home-cooked meal is tossing a frozen pizza into the oven, you may find a large kitchen unnecessary. Or perhaps when you see a yard, all you think is, “that’s something I’d have to mow.” But potential renters may not share those sentiments. It’s important to remember that this house purchase isn’t for you; it’s for your renters. You’ll want something that appeals to as many potential tenants as possible.
It can be easy to default to your own tastes and preferences. Remind yourself that you don’t need to live in–or even like–the property. Its job is to please renters, not you, so shop accordingly. They may happily mow that lawn so that their Golden Retriever and three children have a yard in which to play, and that huge kitchen might be ideal for someone cooking for a family.
Seek Out the Best Location
There’s a reason real estate agents often wax poetic about “location, location, location.” Your property’s location can make or break your investment. Houses, even just a few streets away from each other, can have drastically different rental rates and appreciation histories. While past performance doesn’t guarantee future returns, looking at the recent history of a property’s value can be instructive, as can researching rental rates in the same neighborhood.
Have property values been increasing in the area? That’s a good sign. Does a potential property have easy access to shopping, dining, and other amenities? Is it part of an association that offers attractive benefits? Those things draw renters to a location and push up rents. Are there plans for expansion in the area? That can be great for your property value and tenant pool. However, if the development means construction crews and noise in the direct vicinity of a potential property, that could be problematic.
Keep in mind that you don’t need the property to be near your home. You may find better deals and rent-to-purchase-price ratios in another area or even another state. For assistance finding properties outside your area, consider working with a real estate investment company. Their business is finding phenomenal rentals, enabling them to direct you to strong rental markets.
If the home type is likely to attract families, buying a property in a weak school district will hurt your chances of getting maximum rent and may also slow your appreciation rates. Proximity to a commuter train station is great, but proximity to train tracks and the noise they bring is not.
All these factors go into evaluating a property’s location. It’s worth spending time getting to know the area before you decide to put in an offer.
Decide How Much to Finance
Your lender will likely have requirements on the minimum percentage of the purchase you need to put down. Beyond that, it is up to you. Some novice real estate investors feel tempted to pay as much cash as possible, financing the bare minimum. That makes the monthly numbers look great. With little or no mortgage payment, you can pocket nearly all the rent. However, that ignores the benefits of leverage.
For a $300,000 home bringing in $2500 per month, after taxes, maintenance, and other expenses, you might see about $22,000 net annually. That would be an annual return of about 7.3% if you paid the full purchase price upfront. Not too shabby.
However, if you used leverage to your advantage instead, here’s what that same property might look like. You put down 20%, or $60,000, and finance the rest at 5%. You’d have approximately the same $7000 in expenses and $30,000 gross rental revenue as in our non-leveraged example. Your annual mortgage payments at 6% would be about $16,800, making your net $13,200. With only $60,000 invested instead of the full $300,000, your annual return is 22%. That’s more than three times the return if you paid cash for the home.
And the numbers look even better after you factor in the principal pay-down with your mortgage payments and the growth you’d see in all the money you didn’t put into the house. That cash might allow you to purchase additional rentals or diversify into other appreciating assets.
It may seem counterintuitive, but it is usually best to put down a modest down payment and finance the rest of your investment property.
Novice investors often get tripped up by impatience with what should be a long-term investment. Go into your purchase planning to buy and hold the property long-term. That allows you time to benefit from the natural rise in property values and rents over time. It also means you lose less of your profits to transaction costs associated with buying and selling. The tax benefits of real estate investing also heavily favor long-term ownership.
If the numbers on a property look good today, remember that in a few years, they should look even better. While there will undoubtedly be some dips or plateaus along the way, property values and rents increase over time. Collecting rent 20-years-from-now on a property with a today’s-price mortgage will feel amazing.
As you property-shop, remind yourself that you are in this as a long-term investment. If your financial picture changes and you can afford a larger or more luxurious property, buy a second unit instead of upgrading your first purchase. In most cases, it is best to stick with your initial property and add more homes to your portfolio rather than upgrading and starting the clock over on your investment timeline.
As you are starting out, remember that this is a long game. Set your expectations accordingly.
Keeping these tips in mind as you prepare to purchase your first investment property can help guide your shopping and ensure you are prepared to jump when you find a great rental home. You only get one first rental purchase, so make the most of it.