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So, you're ready to make that leap into the world of property ownership.
Congratulations! Many people seeking financial independence have found that rental properties can be a great way to go.
When you consider the fact that you're basically acquiring income-producing assets that could theoretically provide you with a revenue stream for decades to come (not to mention building equity in each of the units you own), it makes sense why this is such a highly regarded business opportunity.
I've got big plans one day to own rental properties. This past summer, I even went so far as to make at least two offers on some condos in a nearby college town.
Although neither of those offers ended up being the winning bid, that doesn't mean I'm giving up. I’m sure I’ll try again in the near future and absorb as much knowledge as I can in the meantime.
Whether this is your first or tenth rental property, there are certain rules that you should follow in order to make profitable choices that you won’t regret later.
Here’s what you need to do to find the best rental properties at a great price.
Before Searching For Rental Property
It's all too easy to listen to success stories about becoming a landlord and get excited. If you’re anything like me, the next time you drive past a house with a “For Sale” sign, your mind starts to race and you start getting some big ideas.
However, before you take any action whatsoever, you must get yourself prepared for the responsibilities that you’re about to take. Here are some things to think about before getting into the rental property game.
Are You Ready Mentally?
Let's be real … not everyone is cut out to be a landlord. And honestly speaking, this has been one of the main reasons for my own hesitation.
Everyone always talks about rental properties as if they are a fantastic source of passive income. In some situations, they certainly can be. But be aware that not all situations are the same.
I've heard my fair share of rental property nightmares. This includes everything from calls in the middle of the night about the furnace going out to tenants who are trying to avoid you because their rent is behind.
I used to have this client who owned a multi-unit rental property. He told me about how he had to go there on Christmas one year and evict someone who was several months behind on their rent. Sad, but he had given them plenty of opportunities and had finally reached his breaking point with this tenant.
Before you start putting any effort into researching properties, ask yourself: Am I ready to deal with issues like this? Am I comfortable being the “bad guy” if things get tough?
What Type of Rental Property Do You Want to Purchase?
Not every rental property has to be a single-family home and rented out to a family. This is just one type of demographic out of many.
In reality, rental properties come in all shapes and sizes and appeal to niche groups of tenants. For example, would you consider looking in:
- College towns with lots of undergrad and graduate students
- Metro areas with lots of businesses where young professionals may choose to live
- Coastal areas that would make good vacation destinations
- Quiet condo communities where retirees would have little to no maintenance
Overall, think about how each of these demographics could play into your business goals and if there would be an advantage in targeting specific types of tenants.
What's Your Price Range?
Wouldn't life be easy if you could just buy the nicest house you could find to use as a potential rental property?
Unfortunately, that’s not usually how it goes. As with all business ventures, you’re usually bound to some kind of a budget. Remember that will include not just your mortgage, but also any upfront repairs and monthly upkeep.
The goal with most rental properties is to generate the greatest amount of monthly net income possible. That means charging as much as you can for rent while at the same time finding a property that is reasonably priced (preferably at a discount).
Generally speaking, lots of single-family homes usually fit these criteria, and it's one of the reasons why they’re so popular among investment property empire builders.
Keep in mind this will change depending on your target demographic. For instance, if you decide that you'd like to have a rental property in a popular metro area or vacation destination, then you might have to spend considerably more for it (… think places like Hawaii).
If you're not prepared to finance such a project or you don't feel comfortable taking on that much debt, then perhaps you might want to circle back to what your rental property goals should be.
Finding The Right Rental Property
After you decide that you're mentally ready and willing to take on the challenge of property ownership, it’s time to grab a cup of coffee and start getting down to business!
Looking for good rental properties can be an exciting process. Looking through all of the different listings and imagining that one day one of them will belong to is fun.
However, before you get too caught up, there will be some green and red flags that you'll want to be mindful of before they make the shortlist of possible candidates.
What's Available in Your Target Area?
First things first, let’s start by pulling up your favorite online property listing search tool. I’d recommend using any of the following:
Take a look at what properties are listed, their condition, how long they've been on the market, etc. Do any of them match your criteria for demographics or price?
Are There Other Rentals Nearby?
How many other rentals are in the neighborhood or area that you're considering? Again, you could use one of the property listing search engines or a different tool like Apartments.com to do some basic research.
This could reveal several important insights:
- If there's a lot of other rental properties, then maybe there’s high demand in the area. However, if there are too many other rentals, then you're going to be faced with some potentially stiff competition.
- If there's not a lot of other rentals, then how come? Is there something wrong with the neighborhood or area? Or perhaps you’ve found an under-served market?
What Are Other Rental Properties Charging?
In addition to scoping out the competition, something else you'll want to take note of is the range of rental rates. If you plan to charge $1,500 per month and other similar units are only charging $1,000, then that's going to hurt your chances of finding tenants.
However, if those other units don't compare to the property or amenities that you plan to offer, then perhaps you can command a slightly better rate. It will all be relative.
What's the Condition of the Property?
If there are any known issues or defects that will affect the overall value of the property, then it's required by law that the seller discloses these issues upfront. However, there may be some minor things to consider that are not published outright in the property description.
You can sometimes infer them from the information or photos provided.
- Do they say that the appliances will be included? If not, that means you'll have to plan on budgeting around $5,000 to get new ones.
- When was the last time the roof was replaced? If it was 15 years ago, you might be on the hook to replace it soon.
Additionally, what can you learn from the listing without visiting the property? For example, if the property looks great in the photos but has been sitting for some time, this can be an indicator that there is something beyond the photos that you're not seeing.
I ran into this situation with one listing and when I visited the property in person, it was obvious – the floor slanted towards one corner of the house. That was a giant red flag of potential foundation problems. No thanks!
How's the Rest of the Neighborhood?
Sometimes as you're browsing through listings and looking around on Google Earth, you might start to suspect that these properties could be in a bad part of town.
This is when you’ll want to take your search one step further and see what the crime rates are for the area.
This can be done using sites like CrimeReports and SpotCrime. Security system company ADT also has an interactive map that will tell you what kind of activity is going on in any U.S. neighborhood.
Are There Nearby Attractions?
Are the properties you’re considering next to something that would be desirable for someone in your demographic? For example,
- If it’s a single-family home, is it near schools and playgrounds, grocery stores, or the expressway?
- If it’s for college students, how close is it to campus?
- If it’s a vacation area, how close are you to the beach or other tourist spots?
Are There Upcoming Developments?
Finally, has there been any recent news to renovate or revitalize the downtown area?
Could this be a desirable place to live in the next 5 years or so, making it possible that the value of this property could potentially go up significantly?
How to Determine if a Property is a Good Value
Now that you've got your shortlist of potential property listings in mind, the next step is to see if they make any sense financially. The best way to do this is to perform a few small calculations and consider a few basic metrics.
Everyone likes to buy something when it’s on sale, right? This is especially important when we're talking about an investment property.
After you start to survey the market and pick your targets, the best-case scenario is to look for opportunities that are below market value. Ideally, 10 to 20 percent off of the property's value would be ideal.
The reason for this is two-fold:
- The lower the price of the property, the more your cash flow could potentially be every month.
- When the markets are up, if you did have to sell the property, then you'd have a much better chance of making some capital gains on it.
Again, be careful of discounted properties. Just because a listing seems undervalued on paper doesn’t always mean it’s a deal.
Here’s another fun story. When we went to look at a condo that we wanted to use as a rental property, we noticed it had been on the market for a few weeks and it was $10,000 less than its estimated value.
When we took a visit to the property, we immediately found out why: Cat pee! The whole place smelled awful, and we knew that it would have taken probably more than the $10,000 discount just to bring it up to normal human standards!
In business, any time you're about to start a new business or make an investment, one metric that can tell you if it’s worthwhile or not is ROI or return on investment.
ROI is determined by taking your anticipated annual cash flow and then dividing it by the upfront investment.
- Let's say you've got a potential property in mind that will generate $1,000 of revenue per month. However, after subtracting the mortgage, taxes, etc., and adjusting for equity gains, your real monthly gain will be closer to $400 per month (or $4,800 per year).
- Let's assume this property costs $120,000. Between a 20 percent down payment ($24,000) and some up-front repairs that would need to be done to the property ($5,000), your total initial investment would be $29,000.
- Therefore, the ROI = $4,800 / $29,000 = 0.166 or 16.6%
Ideally, if the ROI is 15 percent or more, then the investment is a good prospect. However, if it’s less than that, then perhaps you should move on.
The 1 Percent Rule
Similar to ROI, another metric that can tell if a property is worth pursuing is the 1 Percent Rule.
This is found by taking the following:
- Start with the cost to purchase the property plus any initial repairs you'd plan on making. Using our previous example, this would be $120,000 + $5,000 = $125,000.
- Now calculate 1 percent of this value: $125,000 x 0.01 = $1,250. This is how much you should plan to charge for monthly rent.
In our case, since we estimated we could only charge $1,000 per month for rent, this property would not pass the 1 Percent Rule.
The Cap Rate
One more metric for rental properties to consider is something called the Cap Rate. This metric looks to the future to determine if you'll be happy with this property as an investment.
Here's how to find the Cap Rate:
- Determine the actual cash flow. Again, going back to our previous example, we found that our net income would be about $400 per month (or $4,800 per year).
- Next, take the property cost plus any repairs. Again, we’ll use the previous cost of $125,000.
- Finally, divide the net income by property cost = $4,800 / $125,000 = 0.0384 or 3.84 percent.
Now you have a better understanding of what your true investment is worth. Would you be happy with a return of less than 4 percent per year? Would you rather invest in another type of asset that produces a higher yield? Is there another rental property prospect with better returns?
As an investor, these are all the kinds of financial hurdles that you'll need to clear before you should even put any money into the project.
Unfortunately, if you aren't honest with yourself about these numbers or fudge them in any way to make them seem better, it could end up resulting in a costly mistake later that could have you bleeding thousands of dollars every year.
That's why I always insist: Please be conservative in your estimates.
How to Get Started
Okay, so by this point you've done your homework, found a good property, and the financials make sense. The next logical question is where do you go from here?
If you're planning to fund this venture using cash from a bank or lender, then the first step will be to get pre-approved. The pre-approval process is fairly straightforward and only requires filling out an application with some basic financial information (how much you make per year, your debts, how much you plan to borrow, etc.)
The result is that you'll receive what's called a “pre-approval letter”. This is an important document because when you go to make an offer, it shows the sellers that you've already secured funding and are ready to make a deal.
We did this when we were recently looking for condos to lease to college students. I called up our mortgage provider and asked what it would take to get a pre-approval letter. They were able to send me one relatively fast, and I believe that was a big help in getting the attention of the sellers.
Cash to Close
Regardless of whether you need just a down payment or to plan on making a cash-only offer, you're going to need access to money – and a lot of it!
Typically for investment properties, if you plan to get a mortgage, most lenders will only work with you if you have 20 percent or more to use as a down payment.
Unfortunately, it’s not like with your primary residence where you could get a mortgage with as little as 3 percent.
Obviously, if you plan to leave the banks out of it and make an all-cash offer, then you're going to need a pretty hefty sum of money. Some possible options may include:
- Your personal savings
- Borrowing against your 401k
- Withdrawing contributions from your Roth IRA or Roth 401k
- Borrowing from friends and family
- Applying for a home equity loan
- The sale of your primary residence or another investment property
Each of these methods has its own pros and cons. So please look into each one and consider how it could impact your specific financial situation before taking any action.
Cash for Repairs
Chances are that unless you found a really incredible investment property, it’s not going to be turn-key and ready for move-in on Day 1. Therefore, you’re going to want to have some additional budget or funding available for any necessary repairs or upgrades.
This was true of almost every condo we looked at. Some were in better condition than others with more modern upgrades like newer appliances, fancier countertops, etc.
Even for the units that were in good condition, we still would have had to invest some money into having them professionally painted and steam cleaned. Again, take this into account when you're doing your calculations, and definitely don't fool yourself into thinking that it will be cheaper than it really is.
Assemble Your Team
There are a lot of people who try to make purchasing an investment property a one-person operation. But from what I hear from successful entrepreneurs in podcasts and YouTube videos, the best way to do this successfully is not to do it alone.
Their secret is that they assemble a “team” of people that they can rely on for help.
So who should be on your team?
A lawyer – Legal advice is priceless. Before making any offers, meet with a lawyer who can explain the local ordinances and rules for landlords. This one visit could save you months of future legal battles!
A CPA (certified public accountant) – Business taxes are an area that most of us are not familiar with. But for a CPA, this will be no problem. They can guide you on what to keep track of as well as let you know the best strategies to optimize your tax situation so that you’ll pay as little as you have to.
A general contractor – Depending on the scope of what needs to be done to the property, a trusted general contractor will be able to hire out all of the jobs, big and small. Additionally, they will let you know what aspects of the property are up to code and provide you with assistance during inspections.
Smart Moves Going Forward
What makes the world of real estate so complicated is that there's a lot more to it than just buying a property and finding tenants to fill it.
As a landlord, you'll have legal obligations and responsibilities that you'll have to tend to. This can open you up to an incredible amount of risk if you’re not careful.
With that in mind, be sure you do the following:
Start an LLC
LLC stands for limited liability corporation. Effectively, this is a way to form a separate legal entity that will own your rental property.
Why would you want to do this? Because in the event that something were to happen and it results in a lawsuit, the tenants would sue the LLC and not you personally.
Without an LLC, a lawsuit could mean that they could come after your assets such as your house, vehicles, retirement savings, etc. By forming an LLC, you separate yourself from all of that and build a layer of protection between you and your rental property business.
Hire a Property Manager
This is something that nearly every successful real estate entrepreneur recommends having.
A property manager is a person or service that will take care of all the day-to-day activities that frankly you might not want to bother with:
- Interviewing tenant applications
- Responding to complaints
- Collecting rent
- Performing evictions
- Hiring maintenance
You can expect that this service will cost you a percentage of your revenue. However, a good property manager can make it so that owning a rental property is hands-off.
This will free you up to focus on the business aspects of your investment property so that you can possibly add more homes to your portfolio in the near future.
That's exactly how big-time real estate entrepreneurs are able to scale their businesses upward and assemble portfolios with dozens of properties.
Keep Up on Maintenance
Nothing is going to cause your tenants to complain or possibly take legal action like failure to stay on top of making the property livable. I worked with a guy whose landlord took weeks to respond and fix a leak in the roof.
This ended up ruining some of his personal belongings, and he ended up taking his landlord to small claims court after he moved out.
The best thing you can do in these situations is two things:
- Stay on top of planned maintenance. Regularly swap furnace, water, and salt filters. Keep the yard trimmed. Periodically make sure the furnace, air conditioner, and appliances are all in working order. Keep records of all the things you do.
- Be ready to jump into action if something unplanned happens (like a leak in the roof). Again, this is where having a contractor on your team can be helpful. Also, keep records of when your tenants make complaints and what actions you took afterward to remedy the issue.
Have Cash Reserves on the Ready
Speaking of unplanned maintenance and repairs, there's always also the possibility that your property might go vacant if the tenants end their lease early. Depending on the market, you might not have any income for a while.
To work around this, most experts recommend that you have at least a six-month reserve of cash on hand. That's so if anything goes wrong, you'll be able to float the vacancy until suitable tenants can be found.
Keep Track of All Purchases
For tax reasons, you'll want to record every dollar you spend on your rental property. Things that you might not even think about such as insurance, repair costs, and even the mileage to drive to the property can be considered deductible expenses.
And the more deductible expenses you have, the fewer taxes you'll owe the IRS at the end of the year.
Again, a CPA with some experience in rental properties will be absolutely helpful in this effort. Be sure to find one that you work with and rely upon.
Tips For Finding The Right Rental Property
Finding the right rental property can be an exciting process. But to make it a profitable one, you'll need to be mindful of a few important steps.
Before you even get started, make sure you've got the right mindset to become a landlord. Consider which type of properties and demographic of tenants that you'd like to cater towards. Doing this will also determine what kind of price range you may need to consider.
Next, start browsing some listings using your favorite online search tool. Take note of other rentals in the area and how much they charge. What can you learn about the properties, either from the listing or the photos?
From a financial perspective, you'll want to see if the properties are going to produce worthwhile returns or not. Perform some small calculations and compare metrics such as ROI, 1 Percent Rule, and Cap Rate.
Once you've your shortlist narrowed down, the next step is to get prepared to make an offer. Before you do, be sure to get pre approved by a lender, have cash ready for repairs and closing, and assemble your team.
Finally, don't leave yourself vulnerable to risk. Form an LLC, hire a property manager, and have some cash reserves ready. Be sure to also keep up on the maintenance and bookkeeping for tax purposes.
Remember: Lots of entrepreneurs have made a business out of acquiring investment properties. But they didn’t build their empire by chance.
They did it by mitigating the risks and being selective about which properties to add to their portfolio. Follow these steps towards finding your next investment property, and maybe this will be your ticket to achieving financial freedom.