How To Buy a Rental Property
Investing in Rental property
Rental properties are an extremely popular investment option. And it’s easy to see why. Who wouldn’t want passive income and the possibility of capital appreciation?
However, for many, the process can feel like a decision minefield. At best it’s confusing. At worst it’s intimidating. But buying your first rental property doesn’t need to be that difficult. Break down each step into bitesize pieces. Tackle them one at a time. And you will be a landlord before you realize it.
The following key sections should make purchasing a rental property clear and efficient. Not all may be relevant. For example, some of you may self-manage a property instead of hiring a lettings manager. But all contain key information to help you successfully obtain your first rental:
- Cash flow analysis
- Macro analysis
- Choosing the right location
- Choosing the right property
- Buying the property
- Managing the property
We can’t promise effortless, but we can streamline your approach. So, let’s make sure that your property investment is working as hard as it possibly can for you.
Before jumping into the process, it is always worth looking at whether a rental property is the right investment choice for you. Here are four factors that need to be considered for rental property investments:
- Time and effort. A rental property will keep you on your toes. They can be one of the most active investment options available. The acquisition process can be long and, if not managed by a letting agency, renting the property may eat into your personal time.
- Liquidity. Investing in rental property often involves locking away funds for a long time. Selling a property can take several months, therefore, upfront capital can not be accessed quickly if an emergency arises.
- Capital. Unless buying a property outright, some form of financing is usually required. In fact, using leverage and amplifying returns, is one of the most attractive characteristics of rental properties. However, you still need significant upfront capital to get started. Mortgage providers often require a minimum 20% down payment. Sale costs need to be added on top of the purchase price and the property may require maintenance before a tenant can move in.
- Unpredictability. Passive rental income is a wonderful thing, but it may not always be smooth sailing. Tenants will change periodically which means a property may remain empty for periods of time. Unfortunately, most properties are not tenant-proof either. A roof will leak. Central heating will break. Problems such as these can arise at any time and will eat into rental profits.
Weighing up drawbacks against potential upside forms the basis of any investment opportunity. These key considerations should help you to decide if a rental property is the right decision for you. It’s a popular option, yes, but it’s not the only option for gaining real estate exposure. For a full list of alternative real estate investments, check out our complete guide.
Read the guide: The complete guide to real estate investing
Watch the video: Real estate investing in a post covid world
If you can live with the drawbacks, let’s get into the details on how to buy a rental property.
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Step by step guide
Step 1: Cash flow analysis
The biggest differentiator when choosing a rental property is cash flow. You may feel like you have secured the deal of a lifetime, but if the costs of owning a property outweigh the rent it brings in, money will walk out of your pocket on a monthly basis. Positive cash flow is key. You want money casually strolling in.
Cash flow is calculated by subtracting the expenses of owning and managing your rental property from the rental income that is generated. Although it’s a simple calculation many investors greatly underestimate expenses, so let’s go through a list of potentials.
- Mortgage repayments. Taxes and insurance should also be included in this expense as most mortgage providers require it.
- Utilities. Will there be any utilities at the property still paid by you?
- Property management. Are you going to hire a lettings agency to look after the property on your behalf? Typically, a 10% cut of rental income is required.
- Maintenance. It is good to factor in a monthly maintenance fee just in case anything goes wrong. Something won’t go wrong every month, but by building a buffer it can help to take the sting out of unexpected mishaps.
- Vacancies. A property will not be rented 24/7, 365 days of the year. There will be empty periods. Factor a 5-10% vacancy rate to cover the costs when a tenant is not there.
Make cash flow a priority from the start. Is there anything that will improve rental income? Is there anything that will reduce the rental income? Throughout the remainder of the process always have cash flow in the back of your mind.
Step 2: Macro analysis
Before diving into the local area listings it is a good idea to perform high-level research. This involves looking at the bigger picture, performing a top down analysis approach moving from country down to city. You want those funds to work as hard for you as possible.
Country analysis. If international options aren’t applicable to you then you might be able to skip this part. But if opportunities worldwide are open, you might find better deals abroad rather than at home. When comparing different countries there are some key factors to consider.
- Political risk. Is the government elected and stable? Are there any upcoming changes between your home country and the country you are considering?
- Taxes. What taxes are charged for rental income? What threshold do you have to pass before tax is required?
- Investment options. The country you are considering may have a stable government and it may be tax efficient but if the selection of properties is limited, the chances of finding a suitable deal could diminish significantly.
State/county analysis. Once you have settled on a country. Now it is time to choose a suitable state. This will vary country to country. If you have chosen the US, for example, there are quite a few to choose from.
- Familiarity. It can be an advantage to invest in an area you know well. Is there anywhere you have lived in the past? Is there anywhere that you particularly enjoyed living? Is there somewhere that you would love to retire one day? If you think highly of an area, chances are others will too.
- Taxes. Many states have independent tax laws. Make sure to read up what tax laws would apply to your rental income. You don’t want a higher than expected bill at the end of the tax year.
City/town analysis. Now you must pinpoint a city, or town. And the differences between cities can be huge. If you’re from the US, or a car fanatic, you may remember car manufacturing moving from Detroit during the 60s & 70s, or more recently from Cleveland durings the 90s & early 2000s. Rental properties in both cities took a huge hit. Because the workforce in these cities were so reliant on one industry, there was very little other work remaining for tenants when the industry moved, so suitable tenants left. Luckily, there are some factors you can look at to prevent this happening to you.
- Supply & demand. Most investments work on a supply and demand basis. And rental properties are no different. Look at the rental market for the last 5 years – is demand increasing or decreasing?
- Income levels. For tenants to afford rent, they will require a certain level of income. Check the local income data to determine the population that are employed and what the average income level is. However, beware distorted figures – if there is 70% employed, but income levels are high, there may be a few wealthy people distorting the numbers.
- Population growth. Is the population growing in an area? If it is, chances are more housing will be required – which means more tenants. City-data.com offers useful statistics on population growth in the US.
- Economic diversity. Having multiple industries on your doorstep is crucial. Are there enough job opportunities to keep tenant incomes stable? If their income is stable, your rental income will be too.
Watch the video: How will urban decline affect real estate?
Step 3: Selecting the right location
Okay, so you’ve picked your city or town. But your location within a city is just as important as the city itself. As most of you will know, not all neighborhoods are created equally.
- Demand & employment. Try to organise neighborhoods by supply and demand. Are more people moving in? If there are, it should be a good indication that you will find suitable tenants and that there is enough industry nearby to support them. High employment opportunities lead to a concentration of people, which means there will always be new tenants looking to rent.
- Crime. High crime levels are a deal breaker. So beware if house prices are relatively low – it may be for a reason. Compare the crime statistics for each neighborhood and drop yourself into Google Street View. Are houses well kept? Who do the local shops serve?
- Development. Local councils often earmark neighborhoods for regeneration and any development plans should be publicized. Check to see if any future plans may improve or detract from a neighborhood. Ideally, you don’t want to read that 6 months from now developers are building a new shopping mall at the end of your street.
Remember, if you wouldn’t want to live there, tenants are not going to rent there either. There’s no moving the house once you’ve got the keys.
Step 4: Choosing the right property
Start with a comfortable budget. This can greatly reduce the time it takes to search. Begin searching for properties that fall within that price criteria.
When searching, you will begin to develop an understanding of market prices. Look at similar listings and become comfortable that the asking price represents the quality of the house. Many mortgage providers will require a valuation to be completed. Are you looking for a ‘fixer-upper’ that you can add value to, or are you looking for one that a tenant can move into straight away?
When you have a shortlist, make sure to understand what rental payments you might expect from the property. Has the property been rented before? If not, look at what similar nearby rental properties are fetching and work that into your cash flow predictions. A general rule of thumb used by many investors is that a rent should be approximately 1% of the purchase price plus costs or another way of looking at it is that the property should cost no more than 100 times the monthly rent.
Once you have determined your purchase price, rental estimations, and potential expenses, there are a couple of other calculations to help you evaluate returns. These include the cap rate, or yield, and the return on investment (ROI).
- Cap rate. This is what a property may bring in annually compared with the purchase price. If a property is purchased for $200,000 and rental income is $10,000, the gross yield would be 5% (the math – ($10,000/$200,000) x 100). The higher the yield the better returns. Net yield can be calculated by subtracting annual costs from the annual rental income.
- ROI. Although similar to yield, the ROI is the annual rental income, minus costs, measured against the value of funds invested – instead of the total purchase price. For example, the net annual income is $8000 after costs. If the property price is $200,000 but a $150,000 mortgage was used, the total upfront investment would need to be $50,000. This means your ROI would be 16% (the math – ($8,000/$50,000) x 100).
For those that are looking for some extra tax relief, you can also calculate depreciation costs.
- Depreciation. When renting a property, the depreciation of the property can be deducted from taxable income. According to the IRS, the useful life of residential dwellings is 27.5 years. Therefore, a property that costs $200,000 would have a yearly depreciation value of $7,272 (the math – $200,000/27.5). Although this is a crude example, and the true calculation has more factors involved, it is a useful starting point for potential tax savings.
Before finalizing a choice, bring in a trusted property surveyor to certify that you are choosing a solid building. Don’t get caught out by any hidden structural problems.
Read more: How to buy a foreclosed home
Step 5: Buying the property
Unfortunately, due to all of the third parties involved, this can be the slowest part of the process.
Before placing an offer on a property you must determine how it will be financed. Are you buying it outright? Or are you applying for a mortgage? Although the process can be slightly simpler when a bank is not involved, financing can often amplify returns. As mentioned previously, typically a minimum 20% down payment is required by lenders.
If you have bad credit, begin working on your credit score as soon as possible to avoid disappointment when looking for financing options. To understand where you stand in the rankings, use a dedicated credit bureau that focuses on obtaining accurate credit reports. Experian, Equifax, and TransUnion are three examples that offer services to US customers.
A property conveyancer, or solicitor, must be hired to fulfill the majority of checks and property deed transfers between you and the seller. When searching for a solicitor remember to search for options and check their prices are competitive. Do they have any relationships with local districts or councils that may help you?
Once the purchase is complete, your property will need to be insured. While home insurance will cover the structure after purchase, landlord’s insurance may be required when renting the property.
Step 6: Managing the property
The final step in the process to consider is management. This covers all aspects of finding tenants, performing necessary background checks, and maintaining the property if there are any issues. There are two options at this stage.
The first is to hire a local letting agency to market and maintain the property for you. Although a percentage of the monthly rent will need to be paid, all management worries are handed over to them.
Alternatively, you could manage all aspects yourself. There are certainly plenty of investors out there that take this option as its results in higher monthly returns. However, the buck stops with you. You will be the one called at 1 am in the morning when the drainage stops working or the central heating breaks.
It is smart to diversify an investment portfolio. We all know that. Otherwise, you wouldn’t be here. And when it comes to diversification, rental properties are usually a high item on investor’s hit-lists. A rental property is a property purchased with the intention of renting to tenants. In comparison to stocks or bonds, rental investments allow you to leverage funds for amplified returns, generate passive monthly income and invest in a market that is not correlated with global equities or commodities.
But a rental property is not an everyday purchase. It takes time to consider the variables involved and become comfortable that the investment will generate positive cash flow month after month. So, take time to follow the steps within this guide. A little homework goes a long way with rental property investments.
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