There’s no denying that real estate can be a lucrative investment. And investing in an investment property is a great way to diversify your portfolio and protect yourself against market fluctuations. So, what are some key things you should know before buying an investment property? In this guide, we’ll discuss everything from how to find rental properties to managing your cash flow. We’ll also show you our recommended steps for getting started on your first deal!
What is an investment property?
An investment property is real estate that you buy to sell or rent out. You can build wealth with investment properties through cash flow, appreciation, and even tax benefits. These properties can be purchased by individual investors or partnerships and groups.
Risks and Benefits of Owning an Investment Property
When you’re ready to buy an investment property, it’s important to be aware of the risks and benefits involved. This is a big decision, and if you have renters living on your property, you’ll need to be sure you can pay all the bills a landlord is typically responsible for. But, if you’re able to do this right, you could bring in some serious cash flow or home appreciation simply by owning real estate. For a deeper dive, here are some of the risks and benefits of owning an investment property:
Risk 1: Unprepared Investors Can Get Hurt
On your first real estate deal, don’t be surprised if (more like when) things go wrong. An investment property can unexpectedly require thousands, or tens of thousands, in repairs for big systems like the roof, HVAC, plumbing, and more.
Want to avoid this? Have a good cash cushion before you buy.
Benefit 1: Cash Flow Can Make You Financially Free
Cash flow is the bread and butter of real estate investing. It’s what pays your mortgage, your property taxes, and most importantly, you for investing in the property. A single-family rental may make you an extra $200 or so per month in pure cash flow, but a large commercial property could make you $10,000 per month! Regardless of what you invest in, investment properties can rapidly accelerate your path to financial freedom.
Risk 2: Troublesome Tenant Headaches
Having a bad tenant can be the difference between a successful investment and one that goes horribly wrong. These types of tenants can keep you constantly busy, fixing things that weren’t broken to start with, and rarely paying rent on time.
Want to avoid this? Get a great property manager or learn how to screen tenants like a pro!
Benefit 2: Long-Term Wealth Can Build in the Background
The biggest long-term wealth builder of investment properties? Appreciation! Your investment property can sit for years while you slowly watch your equity increase. Even better? Upgrading your property or performing a full-on renovation can add tens or hundreds of thousands in instant equity!
8 Considerations Before Buying an Investment Property
Before you buy an investment property, there are eight considerations you’ll want to take into account:
1. Housing market trends
The first thing you should do is research the local housing market in your target area and find out how long it has been trending up or down. If there’s a trend of rising prices, this might be a good time for investing in a property; but if the trend has been downward for several years, it may be wiser to wait for prices to rebound before buying an investment property, or ditch that market entirely.
2. Interest Rates
Interest rates can make a big difference when purchasing an investment property because they affect both the amount of debt service you’ll need to cover your mortgage payment each month as well as how much cash flow (or profit) will be left over after paying off each month’s mortgage.
3. Cash Reserves
In addition to understanding what type of properties are currently selling well and how much debt service payments would likely be on those types of real estate, one must also consider whether they have sufficient cash reserves available before buying in the first place. Nobody wants to run up high credit card debt or take out a personal loan just to fix a leaky sink. So before you buy, make sure you have at least six month’s worth of mortgage payments in reserve!
4. Location Location Location
This is one of the most important factors to consider when buying a home. For example, if you are looking at properties in the same city but are located on opposite sides of town, one will likely sell faster than the other. This is because more people want to live in areas where there is good access to schools and shopping centers as well as proximity to work. So before you buy, make sure that your chosen neighborhood has these types of amenities! Not only will better amenities lead to higher appreciation, but they’ll allow for a better class of tenants, who will pay more rent and pay on time more often.
5. The 2% Rule
The 2% rule isn’t as much a rule as it is something to guide you in your quest for cash flow. But what is the 2% rule? Well, back in the old days when rental properties were a lot cheaper, investors would shoot for 2% of the purchase price in monthly rent. So a rental property that costs $100,000 should be bringing in around $2,000 per month in rent. In the present day and age, that’s almost impossible, but many investors still shoot for the 1% rule, which is just the 2% rule cut in half!
6. Going Solo vs. Partnering
If you’re a complete rookie in the realm of real estate, you’ll need to ask yourself which type of partnership structure you want to set up. Maybe you just want to buy rentals all on your own, without having to debate with other people about which paint looks best in the kitchen. Or maybe you’d rather partner up with a friend or family member and split profits, while also spitting the down payment! Some investors even strike deals with “silent partners” where the “silent partner” provides all the money and the active investor does all the work, then they split profits down the middle.
7. Fixed and Variable Costs
Running an investment property ain’t cheap! Besides your monthly mortgage payment, you’ll also have property taxes to pay for, utilities (if you pay for them), regular maintenance, capital expenditures (large systems that need replacing), HOA fees, accounting costs, and more. Be sure to factor all of these out before you buy a property, as you could have a rude awakening if you forgot one or two of these major costs.
8. Down Payment Amount
Down payments range based on the property. If you’re buying a traditional investment property, you’ll most likely need at least 20% down. Vacation rentals (with a second home mortgage) may only set you back 10%, and if you’re buying an owner-occupied multifamily property, you can put as little as 3.5% down! Knowing your property type is the quickest way to help you estimate your true down payment cost.
Key Factors for Being Ready to Buy an Investment Property
While many factors play into the decision to buy an investment property, the following ones should be high on your list:
Personal Financial Stability
If you’re not in a position to take on this kind of responsibility, it could lead to some serious financial trouble down the road. You want to be in a position of financial strength, not financial fatigue when you buy your first investment property. This means having strong savings, consistent income, and an accurate assumption of what the property will give and take from you.
Knowing Your ROI (Return on Investment)
ROI is one of the most important metrics in real estate investing. It’s a simple formula but will dictate almost every decision you make when buying, renovating, renting, or selling an investment property. Here’s how to calculate ROI:
You’ll need two things:
- Net Income of Your Property (Your Profit)
- Cost of The Property
Then divide them! Here’s an example:
You bought a house for $350,000. You get $2,500/month in rent but pay $1,800/month in total expenses (mortgage, taxes, insurance, maintenance, etc.) So your net profit per month is $700.
Multiple that times twelve months and you have $8,400 of net income.
Now take the net income and divide it by the price of the property:
$8,400/$350,000 = 2.4% . That’s a pretty bad ROI!
But, you probably didn’t pay $350,000 in cash for the property. Maybe you got a 20% down loan with about $9,000 in closing costs. So your actual investment cost would be $70,000 + $9,000 = $79,000. Now let’s repeat the same equation.
$8,400 / $79,000 = 10.6% ROI. Now we’re talking!
ROI is one of the most important metrics when evaluating a deal. Some other real estate calculations are cash-on-cash return, return on equity, and debt-service coverage ratio.
Basic Property Management Skills
Your property management can make or break an investment property. Even if you’re thinking of hiring a third-party property manager, you should still know some basic property management skills. This includes screening tenants, setting up rent payments, real estate bookkeeping, and basic maintenance. If you feel like you’d be able to manage the property if you couldn’t find a quality property management company, then you may be set to start buying investment property!
The Next Steps to Buying an Investment Property
Once you know what kind of investment property you want to buy and have a general idea of your budget, it’s time to get the ball rolling.
STEP 1: Pick a market
If you don’t already have one in mind, start researching the various cities where properties are currently on sale in your price range. This will help narrow down which markets make sense for your investment goals. Remember that some markets focus more on cash flow while others focus on appreciation. Cash flow markets are places like Cincinnati, Upstate New York, Cleveland, and Kansas City. Appreciation markets are in California, Miami, Raleigh, Austin, and Denver.
STEP 2: Find a House (and an Agent!)
You can use websites like Zillow and Redfin to search for homes that meet all of your criteria – including size, location, price point, and type (single family vs duplex). Once you find a few potential houses that meet these needs, schedule home visits with an agent so they can give their professional opinion on whether or not these houses are worth pursuing further.
When looking for an agent, make sure you focus on finding an investor-friendly agent, as they’ll be much more able to meet your needs.
STEP 3: Secure Financing Options
Before making any offers on properties, start checking out interest rates offered through banks as well as mortgage brokers – local real estate agents should be able to recommend some great ones! Make sure they understand exactly how much money is available or if you want to buy a rental property with no money, before asking them if they can help secure financing; this way they won’t waste time trying to find options outside of what’s available at hand.
STEP 4: Negotiate the Deal
Having a rockstar agent on your team will make these steps far easier. Experienced agents can not only bring the price of the home down through negotiation but help you sweeten the deal with concessions from the seller. This can include things like a home warranty, covering a portion of the closing costs, a seller credit, and more.
STEP 5: Get Insurance
Before you close on the investment property, you’ll need to secure landlord insurance. This differs from homeowners insurance since landlord policies can also protect your cash flow and provide legal protection in case your home (or tenants) gets damaged. Many residential insurance companies provide landlord policies, so call up your local agent and get a quote!
STEP 6: Set Up Property Management
If you are planning on self-managing, it may be best to start reading books on property management. But, if you want to be a bit more hands-off, finding a property manager in your area is a must. The best way to find them? Contact other local landlords and ask for recommendations. You can also join a local REIA (real estate investing association) and ask the members who they trust in the area.
STEP 7: Purchase
Everything is set and ready for you to close. Be sure to reach out to your loan officer, agent, and property management company a few days before closing to ensure that you’re on time for a smooth transaction.
Key Takeaways of Investment Properties
When you’re ready to invest in property, it’s important to remember that this is a significant financial decision. You need to be sure that you have the time and resources available before making any offers on properties. Also, consider talking with an agent who specializes in investment properties so they can give their professional opinion on whether or not these properties are worth pursuing further. Join a real estate investor group or REIA and get local investor advice. The more knowledge the better on the path to purchasing investment properties!
Investment Property FAQs
Need to know a bit more before you invest in your first income-generating property? These questions and answers should help!
There are several ways to invest in real estate. The simplest is to purchase a property that you will live in and rent out the other units (house hacking), or buy a multi-unit property that you can rent out all of the units at once. You can also find an investment property to flip (buy low, renovate it and sell for a profit), or buy properties with plans to hold onto them for many years before selling them for more than what you paid.
The 2% rule states that you should try to buy an investment property that has rents of 2% of the total cost. So, if a property costs $200,000, then you should receive $4,000 a month in rent.
A rental is an investment property but an investment property doesn’t have to be a rental. Investment properties can be numerous things: rental properties, warehouses, apartment complexes, self-storage facilities, and more.
Buying an investment property can help you build wealth, create cash flow, and diversify your investment portfolio. But, investment properties will require a bit more of an “active” role than regular investments like stocks.
