Updated February 28, 2022
“Buy land, they’re not making any more of it.” Those are the words of writer Mark Twain, and they aptly describe why real estate is such an excellent investment. But what if you don’t know anything about real estate outside of your own home and mortgage? How do you jump in to real estate investing?
How to Buy a Rental Property
- Have Cash on the Side
- Consider Low-Cost Areas
- Take Costs into Account
- Review Landlord Tenant Laws
- Decide on Financing vs Buying Outright
- Assemble a Property Management Team
- Protect Cash Flow
Did you ever learn how to swim? At a certain point, that might have involved just jumping into the water with someone nearby watching to make sure you’re safe. The same is true for buying for your first rental property.
Even as we go through all the legal and financial details of entering the world of real estate investing, it’s important to keep in mind that if you really want to get into rental properties, at a certain point, you’ll just have to jump in and buy one. At the same time, you want to make sure you’re surrounded by people who can watch you learn and offer advice when needed. Otherwise, you might get in over your head.
This team of people might include someone in your network—a friend, family member, acquaintance, coworker, or colleague—who has real estate experience and can offer pointers about what to do and what not to do. It should also include a reliable contractor to do work as needed; whether that means making a unit habitable for a new renter or just ongoing upkeep. You should consider a property manager or property management company to handle the daily hassles of responding to maintenance requests and collecting rent. And you’ll definitely need a lawyer to answer any questions you might have to make sure everything is running smoothly on the back end. You will also need a tax advisor to make sure you are protecting your cash flow. All of these real estate professionals will help make sure that your investment is going to profitable.
How Does Real Estate Compare to Other Investments?
Much ink has been spilled over which types of investments yield the best historical returns, with many comparing real estate to the stock market. The actual results of this comparison will depend on the inputs (such as what stocks, indexes, or markets you look at). Really, a blanket answer does not address the nuances that are applicable to each situation. In general, landed assets, like real estate, are viewed as less risky and more stable than priced securities that are exchanged with greater frequency on a marketplace like the stock market.
Overall, real estate is an excellent investment offering great historical returns. Most working people don’t consider real estate as an investment because their investments typically involve the auto-piloted move of allocating a percentage of their paycheck into a retirement account, like an IRA or 401(k). This isn’t a bad move, but if you have some extra cash and have an interest in diversifying your investments, real estate can become a great source of side income.
For some people, it works out so nicely, that they can transition into doing real estate full time. Even if that is not your ultimate outcome, imagine how great it would feel to collect a rent check every month. And if you multiply that by hundreds or thousands of units, you’re looking at an amazing source of cash flow—one that can build lasting and generational wealth.
But let’s not get too far ahead of ourselves. First, you need to buy your first rental property.
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How to Buy a Rental Property
1. Have Cash on the Side
It’s a good idea to have some cash on hand to buy your first rental property. Keep in mind that it’s also nice to have cash reserves on hand in case anything goes wrong, such as a broken water heater, damaged roof, or defunct kitchen appliance.
As for how much cash you need to have, that answer is going to vary based on your personal financial situation. If you have a seven-figure nest egg saved up, there are many parts of the country where you could buy a rental property outright, cash in hand—but does it make sense for you given how close you are to retirement, how long you might live into retirement, and how much income you’d like to generate each month?
One number investors might use to figure this out is the cap rate or capitalization rate of a rental property, which tells you the rate of return you’re going to get on any given property. There is a measure of complexity to this figure that necessitates a discussion with a financial advisor or accountant, but suffice it to say that having cash on hand is useful towards maximizing your ROI and covering any unforeseen circumstances once you’re renting your unit out to an actual tenant or tenants.
2. Consider Low-Cost Areas
You will want to look around and study the real estate market in different places to determine where you should buy your rental property. There are a number of factors to consider beyond the mere price of the property.
For instance, you may be tempted to buy a home in an undervalued area that is just 50 percent or 25 percent of the typical home price in the area where you live—but what about the job market in that area? Will your tenant be able to find a new job and pay their rent if they suddenly fall out of work? By contrast, you might be tempted to focus on hot markets where everybody is buying.
This is where having someone on your team who is familiar with real estate and who has gone through the process of buying homes before can be useful. They can help you look at all the factors involved and find a property in an undervalued area with minimized rental risk.
There are some investors who will search for distressed homes that afford the opportunity to put 100 percent money down with no financing. In other instances, they may take a direct deposit promotion from a sizable credit card line and buy the house in cash. Obviously, this type of opportunity is harder to realize in a more normative housing market, but if you are amenable to renting homes that may be below the standards of something you would pick for your own primary residence, there is a whole market out there to meet those needs.
3. Take Costs into Account
There are going to be a number of costs associated with owning a rental unit. If you are taking out a loan on the property, you’re going to have a monthly mortgage payment. No matter what, you’re going to have an insurance premium. In some cases, you may also be paying for utilities. Perhaps even a homeowner’s association (HOA) fee. There will also be property taxes, which will vary by county. Don’t forget about the periodic expenses relating to maintenance, some of which depend on the geographical area in which your property sits.
For example, if you are going to own a small eight to 10-unit apartment building somewhere in upstate New York, you’re going to need to rent out a bobcat every winter or hire a contractor to clear out the parking lot.
Then, of course, there are a number of small, everyday expenses related to running your real estate investment on the backend, such as the business expense of property management software or paying a property manager to respond proactively to complaints and issues.
It’s also good to meet with your contractor and discuss their typical costs for doing the work that will be a routine part of managing a real estate portfolio. If they are going to be working for you, they will need to be transparent about the cost of items and labor. How much will it be to remodel an interior for a new tenant or to put a rental back on to the market? These are some of the ongoing costs you will need to consider, in addition to up front considerations like the mortgage rate and closing costs of a property.
4. Review Landlord Tenant Laws
It’s important to review landlord tenant law in your state and any applicable amendments relating to the county that your property sits. If you find it difficult to wade through the legalese, have a real estate lawyer explain the pertinent points to you.
For example, there may be considerations you need to keep track of in terms of rent control in regards to how much you can raise the rent every year, if you need to provide notice of that, when you need to provide notice of that, and how (in writing, verbally, etc.). Some of this material may seem banal, but it’s important to consider.
Are you allowed to knock on their door or enter the unit for maintenance or safety purposes? There will be certain policies and procedures around evictions, which is an unfortunate eventuality, but one that you should still be prepared for if you are renting property to a tenant.
Even if you protect your personal assets with an LLC, you still need to proactively stay on top of compliance and legal issues, or risk facing a lawsuit from an irate tenant. Knowing the scope and bounds of the relationship between you and a tenant can go a long way towards minimizing this risk.
5. Decide on Financing vs Buying Outright
Once you have all your ducks in a row, it’s time to put your money where your mouth is. If you’re not buying a home in cash outright or working out a deal directly with the previous owner, you’ll need to seek financing. If this is your first rental property, there’s a decent chance you can get a traditional mortgage from your bank. But that will involve screening your credit and credit score, along with conducting the process of loan origination, which can take months to complete.
When it comes to investing in real estate, there are other options, like hard loans, swing loans, balloon loans, bridge loans, and seller financing. Some of these options are going to have loan structures that are different from what you have with your own mortgage.
For example, many real estate lenders care less about your personal credit than they do about the asset. Whereas a bank has no interest in managing properties and would prefer that you don’t default on a home loan, a real estate lender won’t mind taking the collateral of an investment property and putting it into their own portfolio or selling it to recoup their losses if things go south.
It’s good to have an experienced real estate investor in your network to guide you through potential financing options, and perhaps even connect you to the money you need outside of the traditional bank mortgage.
This is the area of real estate that often requires the most creativity. A truly savvy investor will leverage different skills in math, critical thinking, psychology, and negotiation to put together a favorable deal. In the case of rental properties, getting a better price or more favorable financing up front can result in hundreds, thousands, or tens of thousands of dollars in savings over the years.
6. Assemble a Property Management Team
You may think that if you’re buying a single property or renting out the vacation home you haven’t used in years, you don’t need a property manager or property management company. After all, these companies typically take 10 percent of the rent. But you will quickly learn that having someone else field phone calls and emails from tenants is well worth the extra expense. Property management teams or an experienced property manager will also have insights into the wide variety of situations that can come up, and have some sense of how to deal with them in a tactful and timely manner.
Of course, you are always welcome to manage your own property. However, once you have more than one tenant, you are more than likely going to see that outsourcing this component of owning real estate rentals is very important if the venture is going to be worthwhile in terms of stress-free cash flow or passive income.
One of the easiest ways to protect your real estate assets is not the legal paperwork on the back end (although that’s important), but to proactively take care of the assets with good management. Hiring a property manager to take these responsibilities off your shoulders is already worth its weight in gold, but in many cases, it can also help preserve the longevity of your properties, which can save you additional expenses down the road.
For more tips on how to legally protect your real estate assets, schedule a free strategy session with an Anderson Business Advisor!
7. Protect Cash Flow
It’s not about how much money you make, but rather, about how much money you keep. That’s the adage when it comes to investments like stocks, real estate, or running your own business.
When you work as an employee, there’s not much recourse you have in the way of tax breaks other than what you’re able to claim for things like the Child Tax Credit or Earned Income Credit. But if you run your own business or own cash-generating assets like real estate, the world is your oyster—at least in terms of reducing your tax liability.
For instance, let’s say you sell a property. Are you going to shell out punitive capital gains taxes? No! You can use a 1031 exchange to roll those proceeds into a different property. There are a number of rental property tax deductions you can claim, such as the cost of your property manager, repairs, maintenance, and even backend support like software or computers.
Traveling to a conference to meet other investors? That’s a tax write off as well. Paying an accountant to file your taxes? Write off. The IRS also allows you to depreciate a landed asset over the course of 27.5 years to cover certain expenses. You can also accelerate some of that deprecation by conducting a cost segregation study to separate the components of the asset into different categories, some of which depreciate at a faster rate, offering bigger tax write-offs for those years in question. Schedule a consultation with one of our tax planners to learn more.
Are Rentals Better Than Flips?
Just like much ink has been spilled as to whether real estate investing is better than the stock market, it has also been spilled in the debate about whether flipping homes is better than renting them out.
Take a look at your own single family home and consider how much its value has increased over the years in comparison to the stock market over the same span of time. Now consider how much more a stock portfolio could increase if a trader was successfully buying and selling stocks, and how that growth would outpace holding on to a property with each and every expense—landlord insurance, your mortgage payment, etc. You would think that buying and selling homes would yield a lot more profit.
But as it turns out, flipping homes comes with a lot of headaches. True, you don’t have to screen a prospective tenant each and every time you want to rent it. And you don’t have to carry long term expenses, like mortgages and their mortgage rates. But you do have to hunt for properties, explore real estate finance options, fix them up, deal with renovation surprises and expenses, list the property on the market—rinse, and repeat. Even with the help of a real estate agent, it can be exhausting.
Many people really enjoy doing all this—feeling like it possesses a certain thrill of the chase. Some even like doing everything themselves; from marketing the property to making runs to Home Depot to find a matching banister for the other side of a staircase.
In the end, a lot of it just comes down to personal preference. Some people like to flip homes, while others like to purchase homes and rent them out. Either way, there are tax advantages you can use to successfully grow your net worth with both strategies.
Buying Rental Property is an Excellent Way to Generate Monthly Cash Flow
Buying rental property can seem intimidating. But rental income on a monthly basis from a rental property investment is an excellent, stable source of positive cash flow.
Moreover, in addition to the monthly rent you can collect, the property value of your investment will likely increase over the years, which is a great boon to the property owner in terms of net worth.
In some instances, it may even outpace the interest rate on your investment property mortgage, so that if you do eventually sell the property, despite the fact that you have been paying interest, you will recoup your investment and a sizable return. Even if it doesn’t, though, rental real estate affords you the opportunity to price the rent above operating expenses and interest rates, creating positive cash flow as long as you can keep the property occupied.
To learn more about the wonderful returns you can realize from real estate investing, sign up our Infinity Investing Workshop. You’ll not only learn how to build a successful real estate portfolio, you’ll also learn the secrets of generating long-term wealth. Start the path to financial freedom today!