The Beginner’s Guide to Investing in Rental Properties

The Beginner's Guide to Investing in Rental Properties

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If you’re thinking about investing in the rental housing market, you might be wondering how to start. Like many new investors, you probably have an optimistic vision for your new investment property: reliable tenants, passive income, and ultimately, financial freedom. But how do you get there from where you are now? As with anything else, start with the basics. Understanding even the rudimentary principles of rental property can help you launch a successful investing career.

This includes knowledge of property types, return on investment, mortgages and the legal steps involved in acquiring a property. The research you do beforehand can help you avoid a misstep that could hurt your investment. How to start investing in rental property:

See also: 5 tips for new investors who want to make money from real estate

Deciding between residential and commercial real estate

Before you buy a property, you must decide whether you want to purchase a residential or commercial property. Both ways can help you achieve your ultimate goal of passive income. However, they have some important differences.

  • Residential real estate: Residential real estate is property that you rent out to someone who is looking for living space or a primary residence. Your tenants can be a family, a student, a young professional or someone else. Residential real estate usually has lower acquisition costs. Residential mortgages are also easier to obtain because banks tend to accept lower credit ratings than commercial loans. There is also a higher demand for residential property, making it easier for you to fill up your units.

  • Commercial real estate: Commercial real estate is real estate that you rent to a company. The company could use the property for retail, office or industrial purposes. Commercial real estate requires commercial mortgages that are a bit more complex than their residential counterparts. In some states, buildings with more than five units are automatically classified as commercial real estate for tax purposes. Ask a mortgage officer in your state if this or a similar rule applies.

determine property value

Now that you’ve selected a property type, you need a few options. Maybe you’ve decided on a neighborhood or a few properties that you’re considering. How do you know which is your best move financially? Here are two crucial factors to consider when assessing property value:

  • Location: Location means everything to potential renters. Is the property near business districts, within walking distance of downtown, or otherwise in a convenient location? These factors make the property more desirable and justify higher rental rates.

  • School Districts: Position within a top school district affects the value more than you might think. In fact, school districts are one of the biggest determinants of tenant and buyer demand, and therefore return on investment. Good school districts attract young families who are willing to overcome disadvantage and pay more for a quality education for their children.

See also: Getting Feet Wet in the Rental Property Business

According to the 1% rule

Qualitative factors are one way to measure return on investment, but you should also have the numbers to back up your assessment. Will the property generate constant rental income? Or does the property end up taking more time and money than it can give you back? Fortunately, there is a rule of thumb for assessing the strength of an investment that you can use before making it.

The 1 percent rule states that a property is likely to be profitable if you can reasonably rent it out at an interest rate of 1 percent of the initial mortgage. You should know if the price you are charging is reasonable based on demand and prices of similar properties in the area.

Say you buy a duplex for $310,000. You pay a 25% deposit, which equals $77,500. That leaves you with a $232,500 mortgage. One percent of that remaining mortgage is $2,325, halving it is $1,162.5. If you can rent both units of the duplex for around $1160, the property is probably a good investment.

The 1% rule is a quick trick to assess the potential of an investment. However, this should not be taken as a final verdict. The soundness of an investment depends on many factors, including your current cash flow, the condition of the property, property tax rates, location trends, and other factors. The 1% rule gets you in the ballpark, but do your due diligence.

Financing your property

You have finally decided on a property. If you’re like most investors, you have to borrow money to buy it. That means finding a mortgage lender, negotiating terms, and making a down payment. Let’s break down mortgage types, down payments, and interest rates:

  • Types of Mortgage: There are many different types of mortgages. The two most common are fixed rate and adjustable rate mortgages. Fixed rate mortgages have a fixed interest rate throughout the life of the loan, while adjustable rate mortgages have an initial fixed rate that changes over the life of the loan.

  • Down payments and interest: In addition to choosing the type of mortgage and term (15 years, 30 years, etc.), you also have to make a larger down payment. Larger down payments help you secure lower interest rates because your lender is taking on less risk. Conversely, lower down payments are associated with higher interest rates. Down payments of around 20% are generally considered sufficient.

Also see: How to get the most out of your rental property investments

Legal checklist

As a buyer, it’s your job to move forward with a purchase before problems arise. Here’s what you should do to ensure your investment is properly protected before making it official:

  • Verify title deed documents: A title deed transmitted in a physical deed confirms ownership of a property. Before signing a purchase contract, look at the last file and check if the seller is the current owner. This can be done through a title company or an attorney. Next, check to see if there are any liens on the property. Liens are claims on a property made by a lender when the owner still owes money. Ownership cannot be transferred if there are active liens on it. Finally, the title deeds must be signed by the seller and buyer (you) to formally transfer ownership.

  • Buy title insurance: Title insurance protects you if something objectionable, such as an undiscovered lien, is discovered after the transfer of ownership. Some lenders require it to obtain a mortgage. Title insurance is typically around $1,000.

  • Confirm Property Tax Receipts: Next, confirm that the previous owner paid all required property taxes. Ask the seller directly for receipts or request them from the tax office in your municipality.

  • Conduct an Inspection: Hire a professional home or building inspector to see if there are any issues you should know about before buying the property.

  • Sign a property purchase agreement: A property purchase agreement is a contract between you and the seller. Like any other contract, it covers the price and any negotiated terms of the purchase. Your agent provides the agreement. Communicate with them about any issues or conditions you would like to include.

Every successful investor started right where you are now. The research and commitment you put in up front can also help you achieve financial freedom. You are now ready to buy your first property and start real estate investing.