I’ve been a residential property manager for nearly 12 years, and I’ve gone back and forth for just as long about whether I should purchase my own investment properties. (My decision-of-the-day depends on if I received another arbitrary noise complaint or how many times I called the plumber last week.)
Recently, I’ve started thinking I should own as many properties as I can. That’s because the more I learn, the more I see that if you purchase a rental with a smart plan, you can have a lucrative asset in the long-term.
For the first-time residential real estate investor, owning a rental can seem like a major financial burden. (Who wants to take on two mortgages?) Then there’s the possibility of problematic tenants and constant repairs. But even with those challenges, rentals can offer big payoffs, if you’re willing to take on some risk.
Start with financing
If you don’t plan on living in the property you are trying to buy, then lenders will likely require 20 to 30 percent of the purchase price as a down payment. Also, some banks and institutions don’t even offer loans on investment properties, so do your research.
Don’t have a 20 percent down payment? No problem, just convert your existing home into a rental property and go buy a new home. Most mortgage regulations stipulate that you live in your primary residence for 12 months before you turn it into a rental. Once you’ve lived in your home for a year, you can turn it into a rental then purchase another primary residence with a lower down payment than if you were purchasing an investment property. If you don’t mind moving, this can be a great strategy for acquiring multiple rental properties in a short period of time with a relatively small cash output.
If you’re a first-time homebuyer, and plan to purchase investment properties in the future, you may want to consider purchasing a duplex, triplex, or quad. If you qualify for an FHA loan, or other first-time buyer program, you can get into your first investment property (but you also have to live there for at least a year) for as little as three percent down. Sounds pretty good, right?
Before embarking on your investment strategy, find a trustworthy mortgage lender who has experience helping people purchase investment properties. They’ll be able to go over all the rules governing investment properties and lending, and they can work with you to formulate short- and long-term plans that match your goals.
Know your market
These days, it’s fairly easy to find housing statistics for all major markets. Zillow has good home value and price searches that will give you a snapshot of a particular market. Study the rate of appreciation (how much the average house value increases per year) for both the short- and long-term. If you plan to own your rental(s) long-term (which is usually more than 10 years), there’s a high likelihood you’re going to make money on anything showing over three percent annual appreciation.
How’s the rental market where you want to buy, and what are the vacancy rates? Portland, Oregon, for example, has had extremely low vacancy rates during the last couple of years (from 2.2 to 4 percent). This means that the likelihood of your rental property sitting empty in Portland is low.
One way to determine whether a market is a good place to invest is by calculating the Price to Rent Ratio (PR), which is the median home price divided by the annualized median rent. A PR ratio of less than 20, using today’s interest rates, generally means a place is more favorable to homebuyers, while a higher ratio (above 20) indicates a better environment for renters.
For example, say you can afford to purchase a property for $250,000 and can charge approximately $1,500 per month for rent. Divide $250,000 by $18,000 ($1,500 x 12 months), and your ratio is about 14. So, a good investment, I’d say. (You should also factor in your down payment, mortgage payments, and a surplus for repairs, vacancy, and management.)
Or consider evaluating a potential rental based on the “one percent rule.” That means you should be able to fetch at least one percent of the purchase price in monthly rent in order for the rental to be profitable. For example, if a property costs $100,000, you should be able to rent it for at least $1,000 a month, if you hope to break even.
You can also get an idea of what kind of rent you can charge with a Rent Estimate report from Cozy. Not only does the customized report include a recommended rent price, it shows you what comparable rentals near your property are collecting, so you can understand the bigger picture.
Evaluate property values and profit
Keep in mind, rental rates increase with housing appreciation, so even if you don’t think you’re getting a great value on a property, you should still be able to cover your mortgage with the monthly rental income (given your PR ratio and down payment amount).
Even if you’re not realizing a profit right away (and most investors don’t until year three), remember that renters are paying your mortgage. And, because we know that homes typically appreciate over time, even with dips and bubbles in the market, if you can afford it, and you plan to hold on to the property long-term, now will almost always be the right time to buy.
It’s also wise to understand the market in your area. Is the population growing? Are jobs being added? If real estate has been appreciating quickly and at high rates, how long is the trend expected to continue? Will renters keep moving into the area?
Plan for the unknown before you buy
While some homeowners practice deferred maintenance, you can’t do that with investment properties. Tenants expect a certain standard of living (and the law also mandates those standards), so when the water heater breaks or the roof begins leaking, you must fix it, immediately.
A good rule is to have at least six months worth of rental expenses in a savings account. If your property expenses (mortgage, insurance, taxes, and repairs) are $1,500/month, you should have $9,000 set aside for emergencies, including unforeseen months when the property may sit vacant. Just because you don’t have renters doesn’t mean you get to stop paying your mortgage.
Think twice about fixers
We all dream of getting a steal of a deal on a property, then harnessing our inner Chip and Joanna Gaines—Fixer Upperstyle—and renting it out for top dollar. Not only can a huge remodel end up costing more than you anticipated, it can also take months to complete. Think about it. If you’re remodeling your rental, it means you’re not collecting rent. Vacancy is the number one killer of profit.
Instead, shop for properties that are move-in ready if you want to get a renter into the house immediately. The house doesn’t have to be particularly charming, or have a landscaped yard, but it should be structurally sound and located in a good place.
Be aware of items like the age and condition of the roof, plumbing, electrical, and anything else that could be a costly or time-consuming to fix before tenants move in. The sooner someone moves in, the sooner they’ll begin paying your mortgage.
Or, you can look for a house that just needs some cosmetic work. It might need new paint and hardware, but it has “good bones,” and won’t need anything major like new electrical or plumbing fixes.
Steer clear of “flipped” houses. You’ll likely pay top dollar for someone else’s mediocre remodel.
As a general rule, keep it simple. Renters don’t always demand dishwashers, garbage disposals, or automatic sprinkler systems. And these items can require constant—and costly—repairs for landlords.
What about existing tenants?
You’ve finally found a duplex that seems like a great deal and the description says there are already tenants occupying both units. Score! You may think you won’t even have to worry about finding renters. Not so fast.
For all you know, bad tenants could be the reason the owner is selling. Many times the current tenants will be paying less than market rent, and it can take a long time, depending on the laws in your city, to raise the rents to market rate.
Also, many cities are making it increasingly tough to terminate rental agreements without cause, even on month-to-month leases. Sometimes, an owner won’t even tell the tenants they’re selling the property. This is a sure way to start off on the wrong foot with your new tenants.
If you can, seek out properties that are vacant. That way, either you or your management company can thoroughly screen your prospective tenants.
Hire a property management company
Even though I’ve spent nearly a third of my life as a property manager, I’d still hire a (good!) management company to maintain my rental properties. It can truly be the difference between passive income or working really hard for what is supposed to be passive income.
Not only do management companies have efficient maintenance and bookkeeping systems already in place, they’ll also make sure your rents stay at market rate, so you don’t have to shoulder the burden of raising rents every year.
Research property managers in your area and ask people you know for recommendations. Good ones are out there, I promise, even if it takes a little digging to find them.
Or manage it yourself
If you want to save anywhere from 10 to 17 percent of your revenue, manage the rental yourself and skip property management fees. These days, independent landlords have other options. For example, you can collect rent, screen tenants, and market vacancies online using Cozy, which is free for landlords and property managers. If you don’t want to be completely hands off, it’s a great way to increase your revenue.
Enlist knowledgeable experts in your market
Build a relationship with a real estate agent whom you like and trust. Some agents will tell you that they “specialize” in helping clients purchase investment properties, but any good agent will know how to help you. It’s their job to know the market.
As I mentioned before, find a mortgage broker who can help educate you on your options for purchasing investment properties. Don’t be afraid to shop around. The time you invest will be worth the knowledge you’ll gain.
Some of the best mortgage brokers aren’t tied to a specific bank. That’s because independent brokers will have access to dozens of loan products, while those tied to a specific bank will typically only offer in-house products, which may not be the best option for you.
If you have three meetings with three different mortgage lenders, you’ll be far more educated than when you started, and you’ll probably have a good idea of who you’d prefer to work with. Besides, getting advice and information from real estate agents and mortgage brokers is free. Just don’t sign an exclusivity agreement unless you’re willing to commit to working with them.
The bottom line
If you do your research, surround yourself with knowledgeable advisors, and treat your rental properties as long-term investments, you’ll be well on your way to becoming a successful landlord!