Key Tips for First-Time Investment Property Buyers
Have you been thinking about purchasing an investment property? Getting into real estate is an excellent option for making extra cash or having it as your primary income source. It’s a sound investment as long as you research what it takes to be a landlord and know the ins and outs of investing in properties. If so, below are several tips for first-time investment property buyers.
As with any substantial investment, there are risks. But after reading this guide on what investment property buyers need to know, you can make a well-informed decision about your purchase.
What Is an Investment Property?
Before diving into the details of what you should know about investing in real estate, you need to understand what an investment property is and what it involves.
To put it simply, an investment property is a piece of real estate, whether it is an apartment, duplex, condo, house, or plot of land, that you purchase to generate income. The money earned from an investment property can be through rental income or appreciation.
The property you purchase is not your primary residence. Instead, you rent it to others or fix it up yourself and put it back on the market at a higher price. Some investors sit on these “fixer-uppers” so they accrue even more value before selling.
Below are some pros and cons, as well as tips for first-time investment property buyers.
Pros and Cons of Investing in Property
With any significant investment, there are pros and cons. Check over these factors before you decide to invest in a property.
Pros of Purchasing an Investment Property
Here are the advantages of buying an investment property:
- Investment properties are usually passive income. This means besides the property’s initial investment and upkeep, you can manage a regular job while getting extra revenue.
- You get a break on taxes with an investment property. You can deduct quite a few things from your taxes because of owning and operating a rental.
- If the value of your property goes up, that means you can charge more for rent. Additionally, if you add value to it, you can increase the cost of living there, which means more income for you.
- Potential for less investment volatility. If the property value rises, your investment is worth more when you are ready to sell the house.
Cons of Buying an Investment Home
Below are disadvantages of investing in real estate:
- It takes a lot of time to grasp investing in properties fully. There is a lot to learn, and it can be a challenge if you do it on your own.
- You are fully responsible for managing the property. If it fails, it is all on you unless you are part of a partnership.
- Ready access to investment funds. If you experience cash flow issues, you may not have access to your down payment funds.
- The unknown future costs of maintenance. Let’s face it, renters can be hard on houses. This means some of your profit could be spent on keeping the property in working order.
- The possibility of having a terrible tenant. No one wants to use the legal system to evict or attempt to get payment for damages if they can avoid it so do everything you can to have a fair vetting process upfront.
- Neighborhood decline over time can be an issue so stay abreast of any changes that could affect future property values.
Here are some key things you need to know to be a successful real estate investor.
The first investment property a young buyer purchases will likely be the first home a buyer purchases, period. Consider living in your first investment property for a year before renting it out. REO, or real estate owned, properties are the best source for great deals on nice properties. These are homes the bank foreclosed on, but then failed to sell at auction. Banks are not property managers and do not want that role, so they try their best to get rid of REO properties as quickly as possible. And therein lies the opportunity for newbie investors.
Government-sponsored enterprises like Fannie Mae and Freddie Mac give priority to buyers who will occupy the property immediately. Federal programs like HUD and the VA also allow you to make a smaller down payment on properties you indicate will be owner-occupied. Living in your new property for a year can also help you discover any issues that may arise later when tenants move in. Once you have put your 12 months in, rent the home out and start seeking your second investment property.
Hone Your Landlord Skills
Before researching properties or putting a down payment on a building, hone your landlord skills. Being a landlord means more than just managing who lives in your rental property or who purchases a home you renovate.
Many property owners, especially those who own more than one rental, often complete repairs themselves to save money. When a tenant comes to you and has a toilet that needs fixing or notices chipping paint, you’re in charge of those repairs.
If you don’t have the funds to hire a team of professionals to complete those kinds of jobs, it’s up to you. Otherwise, you risk losing a tenant due to the poor upkeep of the property. It might help to take a few courses or watch videos on basic plumbing, lighting, and how to use tools you would typically see in a toolbox or contractor van.
As you purchase more properties, make more money, and get the gist of being a landlord, you can hire a property manager. The property manager would take care of any maintenance items.
Pay Off Any Standing Debts
Purchasing a property to rent out or resell is a significant investment. When starting in real estate, you want to have very little to zero debt. Some investors who have been in the business might carry some debt as part of their strategy, but you generally want to avoid it.
Typical debts include student loans, a home mortgage on your main house, medical bills, or even if you have college-aged students. Purchasing an investment property requires more financial stability than buying a home or renting an apartment for yourself.
Understand That Investment Property Mortgages Are Different
Mortgages between investment properties and a primary residence differ. Those looking to buy a home as their primary place to live can sometimes find loans that only require a 3% down payment. However, if you’re investing in a property that someone else will live in, your down payment increases, to as much as 20% in some circumstances. Additionally, with investment properties, there is more risk for foreclosure.
To get a mortgage for your investment property, lenders typically want you to have a good credit score. Additionally, it would be best if you had all your debts paid off. Research various lenders to find rates and fees that work for your budget and get preapproved for a mortgage before you begin your search for a property.
Research Your Property Options
Once you have a preapproval for a mortgage or know you can afford an investment property, you can start looking at housing availability.
There are two primary options you can choose from — purchasing a property to fix and flip, or you can purchase a property and hold it.
Fix and Flip
The fix and flip option will take a bit more time and planning. If you’ve seen shows about flipping homes and selling them, that’s what you would be getting into. You have to purchase a property, repair it, upgrade it, and then sell it.
An average flip takes almost half a year to complete, but the demand for earlier completion has made the sweet spot of a flip just a couple of months.
When you flip a house, you want to upgrade it so you can make a profit. This might include installing new flooring, enhancing the outdoor living space, updating appliances, and so on. Flipping fixer-uppers takes a bit more skill and risk than buying and holding.
Buy and Hold
Buying a property that is fit for living and holding it or renting it out is probably the best option for new investment property buyers. It might take a little bit of fixing up, but generally, these properties are move-in-ready.
There is less of a risk in the buy-and-hold method. Plus, you can begin your cash flow earlier than you would if you had to fix a property.
Find a Valuable Location
During the search for your investment property, make sure you’re looking at the housing market and in neighborhoods that will be more profitable. Purchasing a property in a safe area near amenities will bring in the most income for you.
If you get a rental property in a less desirable location or in an area that’s declining in value, you’ll have difficulty renting it out or reselling it. Plus, it will lose value over time rather than increase in value. Locate an area where the population is growing and one that has potential.
Start With a Small Property
Rather than spending your life savings on a multi-family building, start small and invest in one apartment or a single-family home. When you start small, you have more room to grow. Plus, this will help you get used to being an investment property owner without a larger building’s considerable risk.
Even if you have millions of dollars saved up for your first property, it’s still wise to choose a property on the lower end of the price spectrum. There are always unexpected costs involved that you should prepare for. If you spend all of your savings on one property only to realize it needs some work to be sellable or rentable, then you increase your chance of going into debt.
Know the Legalities Behind Investment Properties
As mentioned, once you purchase an investment property to use as a rental, you’ll need to know how to become a landlord. Each state has different legal obligations when it comes to landlord and tenant laws. Being informed of these laws will save you time and money because you likely won’t have to get into legal hassles.
You are in charge of caring for another property that you don’t live in, meaning you need to know your rights and responsibilities as a landlord. This includes lease requirements, tenant contracts, security deposits, fair housing, and eviction rules.
The more you know about the legal conditions, the more you can tell future tenants and develop a clear contract outlining all of the legal aspects of an investment property.
Figure Out If You Want a Partner
Some people going into real estate might want to have a friend or business partner’s help. Those who can’t afford a rental property on their own can enlist a co-investor. That way, you can more easily afford a rental property and the down payment. If you are a first-time investor, make a wise decision on who you choose to be your partner.
Many implications come with having a partner. You have to trust them and be comfortable with them to begin a partnership. Partnerships have both benefits and drawbacks. For example, having a partner could bring you extra money and experience, an equitable division of responsibilities and, overall, a trustworthy relationship.
However, being part of a partnership means you have to split the profits, and there may be times when you disagree and can not come to a resolution.
Property Self-Management vs. Professional Manager
Some investors have no choice but to hire an outside manager—maybe they reside in a different city or don’t know anything about home repairs and maintenance. Regardless, once you rent the home, you become the landlord.
RealEstate.com estimates that a typical outside property manager costs up to 10 percent of monthly rental revenues. But a good manager will also decrease your costs by having electrical, plumbing and other skills, so you don’t have to hire third-party contractors when maintenance issues arise. Self-management will theoretically save you money, but could prove disastrous if you don’t consider yourself a handyman.
Simple Housing Economics
The obvious goal of all property managers is to make money. This cannot happen if the mortgage payment is $1,000 per month and the monthly rent is the same. Granted, you can eventually refinance and lower your monthly obligation. But to turn a profit, the initial investment property must either be paid for in cash or with a substantial down payment.
Do a financial inventory to discover where you can come up with the funds to buy a house outright. Consider cashing out a 401(k) and bet on your property management skills over the stock market for your retirement. You could potentially sell your future annuity payments to a third-party company for a lump sum of cash. Those who aren’t too proud can even move back with their parents for a year and save toward a large down payment.
Property management is not a get-rich-quick scheme. But it can be a lucrative enterprise if done correctly. The key is to have patience and not overreact when/if issues arise.
Calculate Your Expenses and Unexpected Costs
More expenses are involved in properties than just the cost of the property itself. Besides the cost of the building or property, there will be maintenance and upkeep costs year-round. When you become a landlord for a rental, you’re the one generally in charge of anything that goes wrong. Sure, your tenants might pay for some utilities, but they’re not responsible for paying for a leaky sink.
Besides, you should always have money set aside for emergencies. Think about it this way — do you have an emergency fund for your own home and life? The same goes for your rental property. Set aside a good portion of your income for potential emergencies, like a collapsed roof or a fire due to electrical mistakes.
Also, there will be operating costs involved. Some landlords decide to pay for certain utilities. If that’s you, you need to ensure you set aside enough income to cover those costs.
Consider Your Financing and Make a Down Payment
Unless you’re paying cash for your first investment property, you’ll need to figure out a financing plan. You will have to pay for the property somehow, so you will likely need to head to a bank and consider your financing options. Know that financing for an investment property is different from financing for your primary residence, though.
There are a couple of different options when it comes to financing. Remember that preapproval for a loan is a wise decision before you begin looking at potential properties. Here are some standard financing plans:
- Conventional financing: This is a term for a mortgage that you would get from a bank. Your qualifications back your chances of getting a mortgage for a second property. Things like the type of property, credit scores, past and current employment, debts, and any other assets can be factored into conventional financing. Conventional financing is a common and cost-effective option.
- Asset-based loans: Asset-based loans are another common option for investment property financing. Your qualifications are not factored into your chances of getting approved. Instead, this method focuses on the asset itself, which is the property. The lender may look at qualifications but will primarily base your approval on the property.
- Home equity loan: How is the equity on your primary residence? You can certainly tap into that as a financing option. It’s an easy way to get financing. Whether you use a home equity loan or a home equity line of credit, you should be able to finance using your primary residence.
- Second home financing: Lenders typically will offer you financing for a primary residence, investment property, and a second house. If you have a vacation home or a winter home that you live in for part of the year, you could finance it as a second home and then rent it out the rest of the year.
Of course, there are other financing options out there. Do your research and find the option that works best for you as a first-time investor. Once your financing is under control, you can make your down payment on the property. Expect a 20% down payment for an investment property, which is much higher than down payments for a primary residence. Just know there are options for investment property buyers so do not get discouraged if you struggling to find the right deal for your needs.
Investment Property FAQ
Here are several investment property frequently asked questions you may be wondering about.
How much money do you have to put down on an investment property?
You will typically need a large down payment if you are looking to invest in a rental property. Check with local lenders but it is not unusual for investment property buyers to need 15% or more of the asking price.
Is owning a rental property worth it?
Yes, it can be a smart move to generate passive income and increase wealth. Use the power of capital appreciation to your advantage and turn your investment property into a future nest egg.
What is the real estate 2% rule?
A formula to gauge if you will have positive cash flow. Divide the monthly rent by the purchase price. If the total is at least 2% of the purchase price, the property has positive cash flow.
What is the best rental property return-on-investment?
Industry insiders say you should target a minimum of 8% but more aggressive managers point to 12% as a good goal. Taking the necessary steps to realize a strong ROI is paramount to being a successful rental property owner.
Now that you are armed with knowledge to start the process, are you prepared to jump in and become a rental property owner?
Are You Ready to Invest in Real Estate?
Investing in real estate is one of the best ways to earn a passive income. It might be intimidating at first, but once you gain knowledge of the business and purchase your first property, you’ll start reaping the benefits.
You will have to wait a little while to see a significant paycheck, but keep pursuing your dreams of becoming a property investor. If you ever need additional help, work with a partner who has experience or ask a landlord about their experiences.
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