5 Steps: How to Buy an Investment Property
Getting into a real estate requires an investment. Not just of money, but time too. An investment property is a rental property. Investments are always designed for long term gain. The longer you rent the property, the more equity you build.
When the mortgage is paid off, the rent minus expenses is pure profit. It’s a great source of passive income. But being a landlord is a tough job. Finding the right property and the right tenants can be a challenging equation.
But investment properties don’t need to provide housing. A property can be commercial as well.
The first decision you need to make is which type of property do you want to purchase. For the first time investor, we’d suggest residential. (Skip to the steps if you agree.)
Residential or Commercial?
These are the types of properties for both.
The residential market is booming among almost every demographic. Seniors, couples without children high wage earners are choosing to rent. Young couples are having fewer children and waiting longer to have them. The Great Recession of 2008 pushed many homeowners into the rental market. They either choose to stay or can’t afford to repurchase a home.
- Residential properties, especially single-family homes, tend to build equity faster. In the past decade, the number of renters surpassed the number of homeowners.
- Duplexes are a viable contender, but the expectation of privacy isn’t always met. That can lead to tenant turnover.
- Most condominiums discourage rentals which can slow down your cash flow.
- Townhouses can be good rentals, but the lot is not included with purchase.
The market for commercial space is more dependent on economic conditions. Zoning laws can help or hinder investment. The coronavirus and resulting economic contraction are wreaking havoc on the market. The National Association of Realtors surveyed its members on commercial properties. They reported “higher vacancy rates for office, retail, and apartment rentals. Vacancy rates in industrial properties were flat at 5%.”
- Retail space has been in a steady decline for years as shopping shifts online. eCommerce has exploded during COVID19. Quarantine, stay-at-home orders, and fear of exposure have driven sales even higher.
- The situation with office space is still fluid. 2020 has seen a rise in defaults as the economy impacts tenants. Worth noting, workspace sharing has increased in popularity. Growth of telecommuting during COVID19 may prompt a closer look at space requirements.
- Investment in an apartment building comes with a heavy maintenance load. Expect a higher down payment and/or interest rate. The positive side is more renters choose an apartment vs a single-family home.
- As noted above, industrial vacancies are flat. The need for warehousing, storage, and other industrial properties remains constant.
- Mixed-use space is a combination of retail and office space. The size of the property (hotel, mall, office building) there is some uncertainty. Investment now may pay off later but be prepared limited cash flow.
From the NAR report: “The best guess is for the second half GDP growth to be insufficient to compensate for the loss in the second quarter. Therefore, we expect GDP to have contracted around 3% to 5% for the year as a whole and net job losses totaling around 3 to 5 million.”
Drill down on the details here.
Housing is an ongoing need. Rentals are increasing at a faster rate than homeownership. Though there will be some lease defaults, they can be offset with new tenants. Single-family homes and multi-family properties may be the best option for new investors.
The commercial market is going to be volatile through the close of the year. There may be opportunities to invest in undervalued properties during the slow down. As a first-time investor, commercial space may pose a higher risk than residential. They also require more cash or credit.
The rest of this article will focus on residential real estate investment. It’s where a new investor is most likely to be successful.
1. Check your finances
Before you look for a property, look at your bank account and credit score. Your finances will decide how much you can do and when you can do it. It’s better to wait a year than to overextend yourself.
The initial investment should balance risk and return. Don’t assume you’ll be pulling down scads of money right away. Long term, there will always be maintenance expenses and vacancies.
Loans for a rental property will be higher than a personal mortgage. The down payment won’t be flexible and could be higher than 20%. The interest rate will be different too. Make sure you aren’t upside down if you add that loan to your current bills.
This calculator lets you enter values to see what type of income you can expect from your rental. In general you should be able to charge 1% of the purchase price per month to make this a good investment.
2. What property to pick?
Of the five residential properties, the easiest to start with is a single-family home. In 2018, there were about 16 million single-family rental homes in the U.S. rental properties. According to Market Watch, expect another 13 billion rentals by 2030
Single-family homes tend to attract have long term tenants. Tenant turnover is costly. Every landlord has to deal with vacancies, but the less the better. One and two-bedroom homes don’t rent as well as three bedrooms.
Sometimes condominiums are recommended for rentals because they have no maintenance costs. But their rental rates are lower. Condo’s are run by a board. They don’t typically encourage yearly rentals. The properties can be more trouble than they’re worth. If you’re considering a condo, make sure they know you intend to rent it. Ask about any restrictions or fees.
Start your search before you bring in a real estate agent. If nothing else, it helps to familiarize you with neighborhoods and prices. Realtors are salespeople. They want to close the deal. Don’t let yourself get pressured into closing before you’re ready.
Use Zillow and other listing sites to see what’s out there. Even if you’re “handy”, rental properties are a time suck. Collect information on tradesmen, permit offices, and property management firms.
3. Location, location, location
Neighborhood is a critical factor in for reliable tenants. They want more than a house to rent, they are looking for the right place to live. Be smart and strategic.
If you’re renting a property that appeals to a family with kids, look at the schools. Set a reasonable circumference (say, 10 miles) and narrow your property search to that area. If the schools aren’t highly rated or crime is an issue, don’t invest in that location.
There is some logic of buying a property on the edge of an area that’s undergoing gentrification. A smaller property that appeals to younger couples may rent quickly. But the appreciation in value over time is the big win.
Don’t limit yourself to local neighborhoods. You can buy an investment property anywhere if you hire a property management firm. Some markets are hotter than others. Consider waterfront properties for vacation rentals. Go stay in a similar property to get a good feel. (Nice homework!)
The point is to do some research and look around.
4. Finding Financing
Buying an investment property isn’t the same as purchasing a primary residence. Getting a conventional loan will be expensive. The minimum down payment is 20% or more, plus closing costs. Most lenders think that it’s easier to default on an investment property than your home. An approval will require several months of reserves.
There are other options. An asset loan lets the property itself act as collateral for the loan. It doesn’t mean they won’t review your credit or check your income. Lenders use a Debt Service Coverage Ratio (DSCR) to check your eligibility.
DSCR divides the property’s net operating income by its total debt obligations. This is a forecast that looks solely at the investment’s profitability. Net operating income is ((gross income x vacancy rate) – total expenses.) The calculation doesn’t include costs of financing.
An acceptable DSCR will outweigh an investors employment history or personal debt-to-income ratio. Lenders use a ranking system to standardize the process. If your investment property has a net income of $125,000 and is servicing debt of $85,000, the DSCR is 1.5.
Any DSCR over 1 means the debt is covered. When the DSCR is 2 or more, asset-based financing is almost guaranteed. Below 1, this is not the right loan for you.
There might be some workarounds to get a regular mortgage:
- Invest in a duplex and use a unit for your primary residence
- Invest in a home that you occupy some of the time.
- Try using a home equity loan on your permanent residence
If you want to invest, but don’t want to deal with the details, consider a REIT. A Real Estate Investment Trust combines money from investors to purchase real estate.
4. Profitability & Risk
Real estate investments are dependent on cash flow. They aren’t liquid assets. But they have tax benefits and can appreciate over time. Many investors use a 1% rule for gross monthly rental income. If you paid $150,000 for the property, the rent is $1500. Some go higher (2 or 3%) but it depends on the average rental price in that market.
This calculator helps you identify the cash flow for your investment. Use it to pick the right property.
The Capitalization Rate is a calculation that helps investors compare properties. The CAP rate calculation is Net Operating Income divided by the property’s market value. A CAP rate doesn’t include mortgage costs.
The CAP rate indicates the return on your investment, in this case, 7%. That’s better than some bonds and securities. The property value may appreciate over time depending on location and upkeep.
But all properties go thru vacancies, delinquencies, and evictions. For the single-family home above, the rental income can drop to zero. Depending on state law, an eviction can take months. If you invest in a duplex or triplex, look at the CAP rate with half the rent.
5. Property Management
Many first-time investors start out planning to manage their properties. It’s an option but also a huge obligation. The tasks to run a rental are extensive:
- Vacancy Advertising
- Rental Showings
- Tenant Application/Screenings/Background checks.
- Lease signing
- Repairs and upkeep
- Rent collection
This doesn’t include trying to collect late payments or remove deadbeat tenants. Traveling back and forth can get old. Showing and screening takes a lot of time. Background checks aren’t free but skimping on them can lead to problems. Gut instinct and a handshake won’t get you far in today’s market.
Hiring a property management firm is an alternative to self-management. These firms handle all the tasks above. They use digital signatures for leasing and set up rent payments by direct deposit. They handle tenant complaints and repair requests. If you don’t live near your investment property, it’s a must-have.
The cost for the firms will vary greatly, depending on location. Make sure the contract is based on rent received, not rent due. (They don’t get paid if the tenant doesn’t pay.) Most want a percentage, but some offer a flat fee. If you have multiple properties, you’ll see more value. If you just don’t have time, the expense is worth it.
A hybrid model might be better suited for an investor with one single-family rental. Handoff the administrative tasks you prefer not to handle. You can set up digital signatures on your own. Platforms like RentPayment.com charge transaction fees. Apps like Zelle, offered by most major banks, transfer rent money into your bank account. Tenants can get a Zelle app even if their bank doesn’t offer the platform. These are some of the same tools used by property management firms.
Real Estate Investing
Real estate investments are a way to build wealth. Housing is always needed, but tenants are affected by economic downturns. Investment properties are always rentals. They aren’t fix and flip houses. Those are short term gains. If you buy a foreclosed property, expect much higher expenses and a longer ramp-up to rent.
An investor once said, “Find the best property on the edge of the best neighborhood. That almost guarantees the property will appreciate.” Follow these 5 steps to start investing in real estate now.
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