Buying A Rental Property
October 3, 2022
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How To Buy A Rental Property
Are you interested in buying a rental property? If so, you’re about to secure one of the safest and most lucrative investments in today’s market.
Real estate investment is a reliable path to passive income, retirement savings, and financial freedom.
Like many investors, you may be starting from scratch. You might have a traditional job and suffer from burnout, working long hours with little flexibility and few opportunities to pursue other goals.
Owning and operating rental properties can give you greater flexibility, and it’s easier to get started as a new landlord, than you might think. You can build portfolios and start generating passive income while working remotely, traveling, studying, or raising families.
But where do you start?
This article is your checklist for buying rental property—from choosing a type to narrowing your options and making the purchase.
What kind of property are you looking for? Each type has its benefits and considerations. Your choice influences how you’ll structure the lease, pay tax on your income, and manage the property.
There are two broad types of property: residential real property and commercial real property.
Residential properties are rented by individual tenants as principal homes. These are the most common types of residential properties:
- Single-family homes (SFH) are single houses rented to individual families.
- Multi-family homes (MFH) are buildings divided to accommodate one to four families. Each unit in a MFH has its own kitchen, bathrooms, address, and entrance. A duplex is a MFH with two separate residencies, a triplex has three, and a fourplex has four.
- Apartment complexes are groups of buildings with many apartments managed by the same landlord.
- Townhouses are adjacent residencies that share vertical walls. Each unit has a ground-level entrance and no neighbors above or below it.
- Condominiums are separately owned housing units located in a single building. As the owner of an individual condo, you do not own the building; you only own the space inside your unit. You share ownership of common areas (including the building structure itself) with all the other condo owners.
- Vacation homes and short-term rentals are furnished residencies available to rent for a few days to weeks at a time.
Most new investors start with a single-family home or duplex until they establish their footing in real estate. Eventually, multi-unit buildings will be more profitable for your portfolio. These tend to require more attention and expertise to manage. Nevertheless, a complex with a hundred units is much easier to manage (and more profitable) than a hundred individual single-family homes.
Commercial property is rented to business owners for their commercial activities. Retail, office, and industrial spaces are all examples of commercial property.
Commercial properties are more involved investments with longer recovery periods. While residential properties are depreciated over 27.5 years, it takes 39 years to recover the cost of commercial properties.
Analyzing the Local Market
A large portion of what to know when buying rental property depends on the local market.
Now that you’ve chosen a property type, you need a general location. Choose a geographic area (e.g., the west side of Cleveland), then evaluate its market.
Prices vary in different geographic areas. You shouldn’t expect to spend the same money for a house in Austin, Texas, as you would for the same one in Akron, Ohio. Look at a city’s cost of living and average income to estimate how expensive it will be to purchase a property there.
Distance is another factor to consider. Can you easily travel to the area, or will you need to hire someone to be on the ground on your behalf?
Once you’ve chosen a location, start analyzing the local market. What are the typical rent rates in the area? Is there a high demand for rentals? Use a spreadsheet to track addresses, square footage, number of bedrooms, and rent rates for local properties. Then, identify trends and determine the kind of obstacles you’ll face competing for renters in the area.
The neighborhood of the property is also important. Before you visit, research crime rates or ask local police about safety in the area. Then, drive through the area and observe for yourself. Would your ideal tenant live here?
School districts are an understated factor when buying a property. The district zone matters even if your tenants don’t have children. Why? Because homes near good schools are often valued higher, meaning their residents pay higher taxes. If you buy a house near an acclaimed local school, be prepared to charge your tenants more for rent and require higher income up-front to verify they can afford it.
Choosing a Property
You’ve narrowed down the location, found one or two neighborhoods you like, and identified a couple of promising leads. So how do you decide which one to buy?
The answer is partially mathematical: The best property has the highest return on investment (ROI) and cash flow potential with the least risk.
Let’s break down what this means.
Return on Investment (ROI) is the profitability of an investment. ROI for rental property is the ratio of income you’ll earn from the property to your initial purchase. How efficient is your investment? How quickly are you making back what you spent?
Consider a very basic example. Let’s say you buy a house for $150,000 cash, including closing costs and renovations. After your new tenant moves in, you collect $1,500 a month, or $18,000 after one year. Your expenses that year (property taxes, insurance, repairs, etc.) add up to $4,500.
Your annual return or annual profit is the difference between your rental income ($18,000) and expenses ($4,500), or $13,000. Now you can calculate your ROI by dividing this return by your total investment:
ROI = annual return / total investment
$13,500 / $150,000 = .09
Your ROI for your first year is 9%.
An ROI above 10% is considered good, although the 9% in the above example is excellent for your first property. A high ROI means you made a good investment and have cash flow (you’re still making money after all debts and expenses are paid).
Online ROI calculators are especially helpful for complicated situations involving mortgages, interest rates, and inflation.
Remember that you could have a different ROI in any given year after you buy the property. A weak ROI doesn’t mean you can’t improve your financial management over time.
While ROI is important, it shouldn’t be the only factor in your decision. You should also consider the down payment amount as well as the risks of your investment (high vacancies, hidden structural problems, difficult tenants, an unpredictable market, etc.). It’s up to you to find a balance between the possible return and risk that you’re comfortable with.
Acquiring the Property
Congratulations! You’ve chosen your property and are ready to buy it. But, before you do, be sure to check all the legal boxes:
- Read Over the Property Title Documents—Hire an attorney to verify ownership.
- Confirm the Property Tax Receipts—Ensure the previous owner paid their taxes.
- Write a Property Purchase Agreement—Work with agents to settle on a price and outline the conditions of the sale.
- Perform a Physical Inspection—Enlist a licensed property inspector.
These steps help you learn as much as possible about the property’s history before you agree to take full responsibility for it. Skipping any of these steps could cost you later when you discover that the previous owner did not fulfil certain maintenance or legal obligations.
So, is buying rental property worth it? As long as you do your due diligence up front, the answer is almost always “yes.”
Every property acquisition after your first will be easier, thanks to the research you did at the beginning. The more knowledge you gain about property types, ROI, and the rental marketplace, the better decisions you’ll make as you build your portfolio.
Next, you’ll need to figure out how to finance your rental property.