If you’re considering buying a rental property, you’re not alone. In today’s market, rental properties are a hot commodity—and a great way to generate passive income. However, the world of real estate investing can seem daunting if you’re new to the game.
We’ll walk you through the entire process of buying your first rental property. So read on whether you’re just getting started or ready to pull the trigger on your next investment.
How To Buy a Rental Property in 10 Steps
Follow these steps if you’re ready to buy a rental property:
1. Check Your Credit Score
Unless you’re buying a property with cash, you’ll need financing. Before shopping for properties or applying for loans, look up your credit score using a free site like Credit Karma. Your approval odds and interest rate will highly depend on your credit, so it’s helpful to have this information early in the process.
If your credit is damaged, it is time to begin rebuilding it. By paying off some old debt or clearing some inaccurate data from your credit report with disputes, you may be able to raise your score and improve your credit report by a significant amount. A higher credit score could translate into a better APR and terms for your mortgage. Even a few percentage points can mean thousands of dollars in savings over the life of the loan.
Most mortgage lenders require a minimum FICO score of 620, though some are known to lend to those with scores as low as 540. If you think your score may be borderline, consider trying to get above 740 for the best rates. While you may qualify for a loan with a lower score, the terms will be less competitive than for more creditworthy applicants.
2. Determine Your Budget
Pay close attention to your budgetary needs, as overshooting the costs of a rental property can drastically change your profitability calculations. Your budget should reflect your ability to make monthly principal and interest payments as well as cover other expenses like annual property taxes, insurance, and maintenance costs. Also, leave room for additional expenses like repairs and vacancies in your calculations.
The good news is that property taxes and other rental expenses are generally tax deductible as business expenses, which can significantly lower your tax liability. If you’re unsure how much you can afford, many online calculators can help you figure it out.
3. Save for a Down Payment
Saving for a down payment is often the most intimidating step of buying any property. This is even more true for investment properties, which typically have higher down payment requirements than owner-occupied residences. Likewise, the down payment requirement can differ depending on the loan type, and some have lower requirements than others.
Because saving significant amounts of money can be challenging, begin saving for a down payment as soon as you consider investing in a rental property. If you are buying a property with the intent to rent it out, you may be required to have a down payment of up to 25%. Ultimately, the more money you have for a down payment, the less you’ll need to borrow—and the lower your monthly mortgage payments will be.
4. Identify a Target Market
Your target market is where you intend to buy a rental property. This area may be where you currently live, where you have previously invested in other rental properties, where rental demands are high, or other factors.
Consider your ideal renters and where they are most likely to live. Think of their age, educational level, occupation, income level, interests and lifestyle, family size, and other variables that impact housing decisions. A stable rental market reduces vacancies, so also choose an area with attractive public services and amenities.
For example, if you’re hoping to attract families, you might want to look for a property in a good school district. Or suppose you’re hoping to attract young professionals. In that case, consider a property near public transportation or nightlife.
Once you identify your target market, start looking for properties in that area.5. Shop For and Compare Properties
Now that you know how much you can afford to spend and where you’d like to buy, start looking at properties online. Several websites allow you to search for rental properties, including Zillow, Trulia, and HotPads.
In addition to considering budget and location, compare factors that can impact your rate of return—like the property’s condition, average rent prices, and vacancy rates. These details make it easier to calculate a realistic capitalization rate.
Average property values—or comps—can also help choose between two or more properties. Look at the value trends, too. Depending on your investment strategy, consider investing in a neighborhood where values have recently dropped. A community where values are on a slow and steady rise may also be a good investment. Likewise, pay close attention to neighborhood features like schools and shopping.
For example, a fixer-upper in a good school district is likely more expensive than a move-in-ready property in a less desirable area. But if you hope to attract families, the well-situated fixer-upper is probably the better investment.
6. Identify a Source of Financing
As you begin your search for properties, start thinking about financing. You won’t need to formally apply until you get a property under contract, but many lenders offer a prequalification process that shows sellers you’re likely to qualify for financing. While prequalification doesn’t always translate into approval, it can give you an edge when making offers—especially in a seller’s market.
There are many ways to finance a rental property, including loans, lines of credit, and private investors. However, the best way to finance a rental property depends on your credit score, the down payment you can afford, and the type of property you’re planning to purchase.
For example, if you intend to purchase a fixer-upper, you might want to look into an FHA loan or a home equity line of credit. However, a conventional loan may be best if you want a turnkey investment property.
7. Schedule a Tour
Once you find a few properties you’re interested in, schedule a tour at each. Showings allow you to see the property in person and get a better sense of the condition of the property and the surrounding neighborhood.
When touring the property, pay attention to the condition of the floors, walls, and ceilings. Also look for signs of water damage or mold. If possible, talk to the current tenants to get their opinion of the property. While a tour won’t reveal everything about a potential rental property, it should give you a good idea of whether it’s a good investment.
8. Do Your Due Diligence
After identifying a few potential properties, do your due diligence by researching the local market, getting an inspection, and calculating a cap rate. While some of this can be completed during the formal due diligence period, it’s helpful to have an understanding of the property prior to making an offer. Take the following steps before beginning the purchase process:
- Complete an unbiased value projection
- Evaluate the location
- Speak with tenants and neighbors
- Ensure there are no zoning issues that restrict rentability
- Physically tour the units
- Familiarize yourself with the neighborhood homeowners’ association rules
- Ensure the parking situation is adequate for tenants
- Test for any environmental issues
- Collect bids for repairs
- Have the location professionally appraised
- Hire a real estate attorney to research the title
- Get an insurance quote for the property
- Request a record of insurance claims involving the property
9. Make an Offer
Suppose you’ve found a property you feel checks all of your boxes for economic and non-economic factors. In that case, you may think it’s time to make an offer on the property and begin the sales process. If this is the case, don’t simply make an offer close to the asking price so the seller can accept it immediately. Instead, make a fair offer based on the fundamentals behind the potential investment.
For the most part, you’ve toured the property and seen what there is to see. You’ve also had a professional inspection done by this point, so you shouldn’t be short on profitability data. This inspection data can often be leveraged to great benefit when dealing with the purchase price, which means more money for renovations. The seller may also come down on the price if the inspection revealed the property would take substantial work to be rentable.
10. Hire a Property Manager
If you’re not interested in being a hands-on landlord, that’s okay. You can always hire a property manager to handle the day-to-day tasks. A property manager may even be necessary if you already have more than one rental property. Just factor this cost into your budget when calculating how much rent to charge.
Property management companies typically handle all general maintenance for around 10% of the monthly rent for each unit. Property managers also provide marketing and tenant screening services. On the one hand, this can save you time and resources, but using a property manager also cuts into profits.
Pros and Cons of Buying a Rental Property
Buying a rental property can be an excellent way to invest in real estate while producing passive income. However, it’s not the right fit for everyone. Consider the advantages and disadvantages of buying a rental property before committing time and resources to the process.
Pros of Buying Rental Property
- Tax benefits. Many of the expenses related to owning a rental property are tax-deductible. For example, you may be able to deduct things like mortgage interest, insurance premiums, depreciation, and maintenance costs.
- Monthly income. If you charge more for rent than you pay toward the mortgage each month, the property will generate extra income. Depending on your investment strategy, consider buying another property, paying off the mortgage early, or covering other expenses.
- Sweat equity. It’s easy to increase the value of a property without breaking the bank. There are many low-budget home improvement projects that you can handle yourself rather than hiring a contractor.
Cons of Buying Rental Property
- Risk. Most investments come with risk, and owning rental property is no exception. For example, you may lose money if something negatively impacts the rental market in your neighborhood and your units remain unoccupied. Depending on how much you pay for the property, how long you hold it, and your local real estate market, you may lose money on your investment.
- Capital required. In addition to the money needed for a down payment, rental property owners should maintain additional funds to cover unexpected repairs.
- Responsibilities. There are several expenses associated with holding and managing a rental property. As a landlord, you are responsible for replacing appliances that aren’t working, performing background checks on potential tenants, and calling exterminators and other service providers when necessary.
Frequently Asked Questions
How profitable is owning rental property?
The most important factor when determining rental profitability is usually location. Properties in high-demand locations are generally more profitable than those in less desirable areas. Likewise, well-maintained properties are often more profitable than those in need of significant repairs, and properties with access to more amenities can also increase profits.
Of course, the amount of rent you charge and the expenses you incur also impact profitability. If you carefully manage these factors, it is possible to make a good profit from rental properties. However, there are no guarantees, and it is always possible that you could end up losing money on your investment.
Is buying a rental property worth it?
There are several factors to consider when evaluating whether buying a rental property is worth it. For example, determine the amount of cash you have to put down, the property’s market value, and your ability to maintain it. Depending on the circumstances, buying a rental property can be a great way to generate passive income.
What is a good rate of return on rental property?
If you use a cap rate method, a solid return on investment for rental property will be around 10%. On the other hand, if you are using a cash-on-cash method, a suitable range is often between 8% and 12%. However, this is often in the low end, with some investors preferring a calculation that predicts 18% or more.
What type of rental property is most profitable?
The most profitable type of rental property is typically multi-family home units because of the monthly cash flow potential of the complex. Even small four-unit complexes can bring in several thousand dollars per month.
