Though there are many steps involved, the process of buying an investment property is not as difficult if you know what to expect. Buying a piece of real estate that is not your primary residence can serve multiple purposes including personal use, production of passive income, and potential for long-term appreciation of the asset. If you have enough cash and/or sources borrowing to come up with required the down payment, you could be well on your way to owning the next hot Airbnb or VRBO property. Regardless of your primary goal, it's important to understand the rules and methods of evaluation involved!
1. Learn the terminology.
Before you can buy a rental property, you'll need to learn the lingo. An investment property is an asset that generates income or appreciation of value but does not serve as your primary residence. A mixed-use property is one that is partially dedicated to personal use throughout the year, but also generates rental income. Schedule E refers to the section of your tax return where you report income from passive activities. Passive income is when your investment property generates revenue without any material involvement on your part. Finally, property management companies help landlords manage their rental units by completing tasks like screening tenants and collecting rent payments on behalf of the owner.
In recent years, we've also had the incredible rise of short-term rental companies such as Airbnb and Vrbo. These two popular vacation rental platforms can create an instant listing for your investment property for purposes of generating income and managing bookings.
However, there are a number of steps before it comes time to decide how you'll turn your new property into an income producing machine!
Let's keep defining key terminology and process...
If you can cover the mortgage principal, interest, taxes, and insurance with the monthly income, your well on your way to becoming a profitable owner of an investment property. We first recommend making sure you have enough liquidity in your overall net worth to support more exposure to illiquid real estate. From a cash flow pespective, it's very important to be able to sustain a vacancy the property in case you have a tentant issue or need to cover unexpected maintenance costs while the unit is empty.
Negative cash flow, which occurs most often when an investor has borrowed too much to buy the property, can result in a default on the loan unless you are able to sell the property for a profit.
Capitalization Rate (Percentage)
One of the most important variables in this decision is capitalization rate, also known as the “cap rate” or “net rental yield”.
This figure includes all operating expenses for the property and can be calculated by starting with the annual rent and subtracting annual expenses.
Expenses can include repair costs, taxes, landlord insurance, vacancy costs, and other feesAfter that, divide that number by the total property cost and multiply the resulting number by 100 to get the percentage (%).
Intrinsic Market Value = Net Operating Income / Cap Rate
Assume a property is forecast to produce Net Operating Income (NOI) of $300,000 over the next ten years. If it were discounted at a 10% capitalization rate, the property’s market value would be $300,000 / 0.10 = $3,000,000.
2. Evaluate financing options.
You’ll need to have financing in place before you can make an offer on a rental property. The first step is to apply for a mortgage pre-approval, which will show potential sellers that you are serious about purchasing their home and ready to move forward with the transaction at any time. This allows you to be sure that you have enough funds available when it comes time to close on the sale.
Note: Mortgage rates are somewhat higher on second home loans — by as much as 0.5%, 0.75% or 1.0% more. This is in part to compensate for the risk of a second home, which you’re much more likely to walk away from if you weren’t able to make payments compared to your primary residence.
You can take advantage of the equity in your primary residence to make a down payment on a second home, either through a cash-out refinance or home equity line of credit (HELOC). You can also likely deduct the mortgage interest for both your primary residence and second home up to $750,000 total (married filing jointly). This applies only to “qualified” second homes, meaning you don’t rent it out, or you do rent it out but also use it yourself for a certain period of time each year. You can also deduct combined property taxes up to $10,000 per tax year.
For many people, a HELOC (home equity line of credit) is also an important component of their financing plan. A HELOC allows homeowners to borrow against their primary home equity while they continue living in it—so long as they don’t take out more than 80 percent of its value, on average.
This is one of the most important steps to take before buying a rental property. When comparing mortgage rates for different lenders, consider the type of loan that best fits your needs and financial situation.
3. Find a real estate agent to assist with the purchase.
If you're thinking of buying a rental property, it's a good idea to get some help from an expert. A property adviser can help you find the right investment and make sure that it's right for your situation. They'll be able to guide you through the process and answer any questions that come up along the way.
There are many types of property advisers out there, including those who focus on specific areas or types of properties (like apartment buildings). Your best bet is contacting several different advisers in your area and seeing what they have available before deciding which one makes sense for you.
4. Pick a location.
Before you even think about buying a rental property, it's important to understand the local real estate market. In other words, what does it cost to rent a house or apartment? How much income can you expect from your tenants? What are the current macro-level economic trends? The answers to these questions will help you decide where to invest in properties.
To get started with research on local rental markets, contact your state's Department of Housing and Urban Development (HUD). If applicable, HUD may be able to provide data on average rents paid by tenants and the number of units currently available for rent within a certain area based on zip code.
5. Narrow your list of potential properties.
When you're looking for a rental property, you'll want to start by narrowing down your list of potential homes.
First, consider location. Location is important because it can affect whether or not a property is worth the money and effort it takes to buy and maintain. For example, if you want to invest in a vacation home on Maui, that's fine—but keep in mind that this type of property will appeal more to tourists than locals who may be looking for housing close by.
Second, think about price and type of property when deciding which homes are right for you as an investor: some properties will have higher rental rates than others, so make sure you're comparing apples-to-apples. Finally, don't forget about what kind of return on investment (ROI) each property offers; this will help determine how much money each property might bring in over time.
6. Hire a property manager (or DIY)
If you'll be managing the property yourself, that's great! But many people hire a property manager to handle the tenant relationships, maintenance, bookkeeping and other tasks that come with owning a rental. There are a number of private and local property management companies, as well as the large short-term players in the industry such as Airbnb and Vrbo.
Property managers can handle things like:
7. Manage your tenant relationships.
After you’ve found a property, it’s time to manage your tenant relationships. If you want to be successful as a landlord, there are several things that you can do:
Buying a rental property can be great for building long-term wealth and generating passive income streams. You may be thinking: buying a rental property seems really hard! There is definitely a lot to know. Don't worry—there are plenty of resources to help you find success in real estate investing.
As always, make sure that an investment like this fits nicely into your overall financial plan and goals.
We hope we’ve helped you understand the necessary steps and information to know how and when to consider a rental property investment for your situation.
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