Essential Things to Know Before Buying Your First Investment Property
Investing in rental properties is one of the most tried and true types of real estate investments. From individual condos to multi-family homes, rental real estate provides promising opportunities for passive income and appreciating property values. Buying your first rental property is not without its challenges, though. Being a landlord requires you to market the property, track income, and handle all maintenance and tenant issues. If you approach your first investment with the right tips and advice, you can overcome common challenges and enjoy a valuable asset.
Risk & Reward: Is Now the Right Time to Invest in an Income Property?
The rewards of owning a rental property are very appealing. Passive income from one's first rental property can be a viable way to build wealth over time. There are three primary financial incentives to owning a cash-producing property:
- Recurring rental income
- Consistent long-term appreciation
- Tax advantages related to deductions, operating costs, and depreciation
Even better, these perks work together to strengthen one another. Your rental cash flow can often be used to pay down the principal on the mortgage, making it easier to own the property outright and minimize your expenses when it's time to sell. Meanwhile, the tax advantages of being a landlord will help you keep more of your income.
Owning an investment property involves several risks you should be aware of before taking the plunge. Costly repairs, unexpected vacancies, and fluctuating revenue can turn your investment into a cash pit.
Ask the following questions to carefully evaluate your personal and financial situation and decide if now is the right time to buy an investment property.
Do I Have the Right Skills to Be a Landlord?
Rental property owners wear many hats. If you're managing your property independently, you're the CEO, groundskeeper, and customer service person. You need to be patient, organized, and decisive to handle the daily responsibilities of being a property owner.
Do I Have a Financial Cushion?
Your rental property is an ongoing financial commitment. You'll need to save money for repairs, renovations, and vacancy periods. If you're financing your purchase with a mortgage, you should have a solid plan to make payments even if the property isn't generating income.
How Much Debt Do I Have?
Your debt-to-income ratio is one of the most important factors lenders consider when you're applying for a mortgage. A high DTI indicates that you might have trouble making monthly payments and puts you at greater risk of defaulting on your loan. Regarding investment properties, abundant debt overinflates your expenses and can quickly drain your income.
If your debt is too high to buy a rental property at the moment, consider lower-stakes investments to help you bolster your DTI. Investing in real estate investment trusts (REITs) provides new investors with an accessible entry point.
How to Finance Your First Rental Property
If you're ready to buy your first rental property, the process will be similar to buying a primary residence. You'll need to save for a down payment, get pre-approved for a mortgage, and shop around for the right property.
That said, there are a few additional loan requirements for investment property buyers.
From a lender's point of view, rental properties are riskier than primary residences because they're more likely to experience vacancies and aren't always owner-occupied. As a result, you'll generally need a larger down payment (20% is standard) and will be charged a higher interest rate.
Underwriting practices are more stringent for rental properties, too. As a borrower, you need to optimize your credit, save for a high down payment, and present a more favorable debt-to-income ratio than you would for a primary mortgage loan.
While a 20% or higher down payment is the most likely scenario for rental properties, there are a few ways to purchase an income property for lower down payments.
For example, buyers can use an FHA loan to finance their investment with a down payment as low as 3.5%. However, lenders only offer FHA loans for owner-occupied properties. This means they could buy a single-family home and convert part of it to be a rental unit. Or, they could invest in a duplex, triplex, or fourplex and live in one of the units. Multi-family buildings with more than four units qualify as commercial real estate and are not eligible for FHA loans.
Investors can also use a home equity line of credit (HELOC) against their primary residence to finance a rental property.
How to Choose Investment Properties With Potential
A few key things determine whether a property is a good investment. First-timers might want to explore homes requiring low maintenance and a solid history with limited vacancies to ensure an excellent rent-to-value ratio.
Location matters with every real estate purchase, but it's vital for rental homes. The best rental properties are in neighborhoods near schools, public transportation, and nearby popular amenities like grocery stores, coffee shops, and parks.
One of the biggest mistakes new investors tend to make is buying a fixer-upper, which can set up ongoing expenses that are hard to recoup. However, investors with handyman skills or those who know a reputable repair provider may find the light at the end of the tunnel. That being said, experienced investors recommend starting with a rental property in workable condition.
Investors will also want to research the area they are buying to find red-flagged locations with excess vacancies. Try to find places in communities with low vacancy rates that are more likely to lead to regular long-term leases.
Another tip is to follow the 1% rule when investing by considering current rental rates that align with monthly rents equating to 1% of the initial investment in the property.
There are a few other aspects to help you evaluate the viability of a rental property:
- Population influxes
- Employment opportunities
- Percentage of renter-occupied properties
- Vacancy rates
- Median rent trends
- Average housing prices
These details can typically be obtained from local and state resources. This knowledge will be essential in deciding whether an investment is a good one or one to pass on.
Estimate Your Earnings: Double Check Expenses vs. Anticipated Cash Flow
Investors will need to factor in several valuations, including the home's purchase price versus potential rental income, to determine if there is a solid chance of seeing a reliable return on investment (ROI).
- Mortgage payments
- Property taxes
- Property management payments
- Homeowners insurance
- Landlord insurance
- Repairs & upkeep
ROI can be calculated by exploring the property's net annual income after paying for routine expenses and possible vacancy periods. HOA fees will also need to be factored into rental prices or added as an additional expenditure. Before leaping into real estate investments, take a hard look at those personal finances.
Hiring a Property Manager vs. Self Managing
Determine early whether the plan is to self-manage or hire a property management company, what price range is feasible, what rental prices are reasonable, and how much income the property may provide.
Self-managing comes with a host of pros and cons. It generally saves money, but it also requires more time from the investor to handle maintenance issues or complaints. Hiring a property manager can provide some relief, but do your research on companies in the area and reviews before signing any contracts.
Prepare to spend 10 to 25 percent on property management fees, with the higher end attributed to vacation properties versus long-term tenants. In addition to assisting with day-to-day operations, property management companies can help you deliver on business goals, too.
The best property management companies will manage all the relevant records, track your expenses, and maximize your revenue. First-time investors should look hard at hiring a property manager to assist, as there is a lot involved in being a landlord, especially for those who don't live near the property or lack DIY repair skills.
How to Optimize Your Taxes & Deductions
Regardless of whether or not your partner with a property management company, you'll need to be well-connected to have a lucrative investment property. Reaching out to some local resources such as real estate professionals, investment brokers, and contractors will set you up for success.
Taxes can be tricky for rental homes, and a trustworthy account will be one of your most valuable resources. Depending on where you live, your state may have unique tax laws and regulations. Generally, two types of taxes are associated with rental properties: income and property.
The income tax on rental properties is pretty straightforward. You simply need to report all the income you earned from rent during the year. This includes rent from both long-term and short-term tenants. You will also need to report any expenses you incurred from renting out the property. This could include anything from mortgage interest to advertising costs.
The property tax for rental properties can be a bit more complicated. The amount you pay will depend on the property's value and the tax rate in your area. You must also factor in any special assessments or levies specific to rental properties. Some states allow you to claim a percentage of the property taxes you pay as a deduction on your income tax return. Check with your accountant or local tax authority to determine if this is an option.
Rental property tax deductions will help you make the most of your earnings, but there are many important things to know. First and foremost, you can only deduct expenses related to the rental property. This means you cannot deduct the mortgage interest on your personal residence if you also own a rental property.
To maximize your deductions, it's essential to keep good records of all of your expenses. This includes anything from advertising costs to repairs and maintenance. You can generally deduct these expenses on your income tax return. In addition, you may be able to claim a depreciation deduction for the property.
The depreciation deduction allows investors to write off a portion of the property's value each year. This deduction is especially valuable for investors who own high-value properties. Be sure to speak with your accountant or tax advisor to determine your eligibility for this deduction.
Make a Good Investment With the Right Information
Congratulations on taking the plunge into investment property ownership! Owning an income-producing asset is an intelligent way to secure your financial future, and it can be a lot of fun too. As with any big purchase, there are some things you'll want to know before signing on the dotted line. If you do your homework, research the market, and invest in a property that meets your needs, you can set yourself up for a successful first investment.