How Do You Buy Your First Investment Property?

Purchasing your first rental property is a big step for any investor. It’s one of the largest assets you can buy, and with a little bit of time and effort, it can be a great way to generate passive income. But before you become a real estate mogul and start building an empire, you should start with the basics. Knowing how to find a house, get a mortgage and fill it with good tenants are all essential aspects of purchasing your first rental property.

Let’s take a look at the steps you’ll need to take to purchase your first investment property, as well as the challenges you may face along the way. While purchasing a rental property is similar to buying a primary residence, there are some unique differences that you’ll need to consider. With these tips and tricks, you’ll have the information you need to make the process as smooth as possible.

Buying a rental property isn’t for the faint of heart. Not only do you have to consider the mortgage and the operating costs, but you also have to think about the tenants, who can either make or break your investment. There’s usually more risk involved with owning a rental property than investing in the stock market. After all, if you managed to get stuck with bad tenants who don’t pay rent on time, your returns aren’t just reduced – they’re nonexistent. Sure, the stock market may only be pulling in 4% to 5% annually, but you can count on that with some level of confidence. You’re taking a bigger gamble with an investment property.

But with a bigger gamble also comes the opportunity for a bigger reward, and this is especially true for investment properties. In 2016, the average gross yield for rental investors was 9.4%, which is slightly down from previous years but still significant. For some context, the average annual return on the Dow Jones over the last 10 years has been 4.8%. That’s nothing to write home about.

In addition, you have more influence over your investment property than you would the stock market. For example, even if you bought every bottle of Diet Coke in your local grocery store, you probably wouldn’t be able to affect Coca-Cola’s stock price (at least not noticeably). There are so many factors at play. When it comes to the stock market, you’re riding a wave that’s already in place.

With an investment property, though, small changes – such as a new door or some minor improvements to the kitchen – can improve the likelihood of wooing good tenants at higher monthly rents. With investment properties, not only are you riding the wave, but you own the wave. It’s a great choice for that investor who wants a more hands-on opportunity.

A big question for people buying a property, whether it’s an investment property or a primary residence, is “How much house can I afford?” Start by looking at a mortgage calculator to get an idea of rates and monthly payments, and then you can get preapproved to see how much money you qualify for. Make sure that you tell your home loan expert that you’re interested in buying an investment property, which has different rules than a primary residence.

Get Preapproved First

One of the biggest pitfalls that home buyers of any kind make is searching for a property before securing financing. Let’s say, after months of searching, you find the perfect rental property. But by the time you get preapproved for a mortgage, the house is already under contract with another buyer. Get preapproved now and have the ability to jump on a good deal at a moment’s notice.

Another problem with searching before being preapproved is that you don’t actually know how much money you qualify for. It would be heartbreaking to be looking at houses at one price range, only to find out that you qualify for less. Getting preapproved allows you to make an educated decision about the investment property you plan to buy.

For an investment property, you’ll likely use an agency loan, which means the loan would be backed by Fannie Mae or Freddie Mac. In most cases, you won’t be able to get an FHA or VA loan for an investment property. The exception to this would be if you purchase a multiple-unit property and plan to live in one of the units and rent out the others. If you’re planning to go this route, you should start by talking to a Home Loan Expert.

The agency loans available to you will either be a fixed-rate mortgage or an adjustable rate mortgage (ARM). Both of these options have specific requirements when it comes to the down payment and credit score.

What Credit Score And Down Payment Do You Need To Buy An Investment Property?

For a fixed-rate mortgage, the minimum credit score requirement on a single-unit investment property is 620, and it will require a 20% down payment. If you have a credit score of 720 or above, however, you are only required to put down 15% on a single-unit investment property.

For an adjustable rate mortgage, the minimum credit score is 620 and will require at least 15% down on a single-family investment property.

If you’re interested in purchasing a multi-unit property, reach out to a Home Loan Expert to discuss the requirements and options.

Other Requirements To Qualify

Other than the down payment, the requirements for a rental property are somewhat similar to that of a mortgage for a primary residence. You’ll still need to follow the 2/2/2 rule: provide two years of tax returns, two years of W-2s and two months of bank statements to your mortgage company, as well as have your assets verified.

Your mortgage company will also want you to have six months of mortgage payments in reserve in order to give yourself some buffer room in the event that you go through an unexpected financial challenge.

Why Should I Get A Mortgage For My Investment Property?

If you have the means to pay for an investment property in cash, getting a mortgage could still make sense for your situation, especially if you’re planning on getting multiple investment properties. For instance, let’s say that you have $100,000 sitting in the bank. Your first option is to buy a house in cash for $100,000. While you will get a larger cash flow on that investment, it ties up all of your cash in a single place.

If, however, you get a loan with 20% down, you could potentially purchase another house or two at the same price with the remaining $80,000. While your immediate cash flow is lower, these returns will grow in the long-term, especially as rents increase and the mortgages get paid off. You’re building assets at a quicker pace when you go with a mortgage instead of cash.

In the event that you purchase an investment property in cash, there may still be beneficial loan opportunities for your situation. James Milne, a product manager at Quicken Loans, explains that “a large percentage of investment properties in the U.S. are owned without a mortgage, so there is plenty of opportunity to free up cash or take out equity to improve a property. A cash-out refinance is a great option for these clients.” This option can help your investment work for you.

When looking for a great investment property, the first question you need to ask is “Can I actually make money?” If the answer is no, it’s obviously not a great investment. To see how much money your property could potentially make, you’ll need to consider the return on investment (ROI). The ROI can be calculated by first finding the property’s net annual income. This is the rent money that’s left over after you’ve paid the taxes, insurance, property management fees, expected repairs (plan to spend 1% of the property value on this), potential vacancy periods, HOA fees (if applicable) and any utilities that aren’t going to be covered by the tenant. To find the ROI, take the annual income and divide it by the amount you spent on the property. For example, if the net annual income is $7,500 and you spent $100,000 for the property, your ROI is 7.5%.

Use this calculation to see if each rental property is a good potential investment.

When scanning neighborhoods for your first rental, there are a few specific requirements you should be looking for. In a nutshell, you want a house that requires low maintenance, has limited vacancies and allows you to have a good rent-to-value ratio.

No Fixer-Uppers

One of the biggest mistakes that new real estate investors make is buying a fixer-upper. If the ad says the property “needs a lot of TLC,” just move on to the next house. I’ve fallen for this one myself once and managed to get an “amazing deal” on a house that was missing interior walls, required new plumbing throughout and had a basement that flooded on a semi-monthly basis. There are few worse feelings than realizing that your cash cow is actually a money pit.

The exception to this rule is, of course, if you’re knowledgeable about home repairs. If you have extensive handyman skills (or know someone who does), you may be able to deal with these extensive repairs better than I did. But as a general rule, it’s going to be less of a headache to just purchase a house that’s already in workable condition. And they’re out there. So in the meantime, do your best to resist the allure of a fixer-upper.

No Vacancy

If you don’t have paying tenants, your investment property’s not good for much. You want to make sure that your property is attractive not just to any tenant – but to good tenants who pay on time and don’t shove their Cosmo magazines down the toilet (speaking from experience).

Depending on your location, some places just tend to have lower vacancy rates, such as San Jose, Calif., and Fort Collins, Colo., which were both rocking a 0.2% vacancy rate in 2016. You can do some research on the neighborhood you’re looking at, but when it comes right down to it, spend time driving around the streets near your potential property. Simply looking at the level of care given to the houses in the surrounding area can give you a good idea of which houses are vacant and which are not.

The 1% Rule

A big question from new investors is “How much should I rent a property for?” Seasoned investors sometimes use the 1% rule, which states that the rent each month should be at least 1% of the purchase price. For instance, if you purchased a house for $100,000, you would need to charge – at the very least – $1,000 for rent. This, of course, isn’t always true for investors, and some will settle for a slightly lower return.

In order to make sure that a potential property can receive that kind of return, check out Zillow, which offers an estimated monthly rental price – called a Rent Zestimate – that will allow you to get a good idea of the rent amounts in the area. It’s not a perfect measurement, and in my own experience, you can usually get a higher amount of rent than what’s listed, but it does give you a ballpark number.

When you start buying investment properties, you need to take some time to think seriously about your ability to manage your properties. It’s a tough job being a landlord – tougher than most people think – and I’ve seen many an investor become overwhelmed by the time it takes to be a good landlord.

Fun fact: Be on the lookout out for this kind of investor. They sometimes burn out under the weight of their landlording duties and just sell their whole portfolio at once. It’s usually a good time to swoop in and buy.

But the point is that not everyone is cut out to be a landlord. It’s an intense and time-consuming line of work, especially if you already have a day job. For this reason, I highly recommend getting a management company to do this work for you. Sure, you’re probably spending 9% to 11% of the rent on this service, but they will take care of the tenants’ needs and collect the rent. And in the unfortunate event that a tenant needs to be evicted, they’ll help handle that process, too. Time is often more important than money, and letting go of this stress gives you the freedom to pursue additional investments.

Since you’re making income from this investment property, you’ll be expected to pay income taxes, but the good news is that rental properties offer some great tax benefits. Whether you’re hiring someone to make a repair, paying interest on the mortgage or simply driving to your property, there’s a wide range of potential deductions. Words of wisdom: You’ll need to make sure you keep track of these expenses – which means receipts – on the off-chance that the IRS comes knocking. To get the full value of your investment property, you should be making the most of your tax deduction opportunities.

This is another perk of using a management company. They’ll keep track of all of your rental expenses and send them to you in a nice document during tax season. Once again, the amount of time this saves you is worth the money.

While there are many variables to consider when purchasing your first investment property, you should start by doing your research. Look at housing prices and neighborhoods and begin saving for a down payment. And when you’re ready to dive head first into the real estate game, you can start by getting preapproved for a mortgage.