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How to Invest in Rental Property: A Complete Beginners’ Guide

Updated: October 23, 2020

Investing in rental property is one of the smartest ways to secure your future. You not only have an asset that may appreciate in value, but you also have money flowing into your bank account every month. That is — if you do it right.

While a very first walkthrough with your agent may make you want to race to closing, investors who don’t take the time to prepare and research properties can unexpectedly find themselves in a money pit — one that they’ll be stuck in for many years.

Whether you’re a first-time, inexperienced, or seasoned rental property investor, there are some fundamentals everyone must know before signing on the dotted line. But let’s take it a step further. In this guide, we’re going to tell you nearly everything you need to know about how to invest in rental property.

Table of Contents

What is a Rental Property?

Rental property is a type of property whereby an individual or business, known as the “tenant,” uses the space in exchange for money paid to the owner, who is normally called the “landlord.” The two parties are bound by rules set forth in a lease agreement.

Types of Rental Properties

Rental properties aren’t one-size-fits-all. In the rental domain, you have three main sectors in which to rent or invest:

  • Residential
  • Commercial
  • Multi-use

Each category can be broken down into branches of their own. Residential properties are homes in which people live and can include multi-unit homes, small apartment buildings, single-family homes, condos, luxury properties, and more. Investors — especially first-time and novice investors — typically go the residential route as it’s considered the safest and easiest method of investing in property.

Commercial-use properties are areas out of which businesses operate. Commercial spaces span in use, and the usual suspects are storefronts, industrial spaces, and office buildings. But even farmland is considered commercial property. Though apartments are indeed residences, most states have rules that stamp buildings as commercial if they reach over a certain threshold of units (example: a property with five or more units in California is considered commercial property).

Mixed-use properties combine residential and commercial elements. One example of a mixed-use building is a two-story complex with a hair salon occupying the lower half and an apartment on the second story.

For this guide, we’ll mostly be referencing the process for investing in residential rental property, but most of this information can be applied to any type of rental.

Rental Property Statistics

  • 36% of Americans live in rental properties1
  • Renters pay $485 billion in rent every year2
  • Average renter occupancy time in a single-family home: 3 years3
  • 41% of U.S. adults ages 35-44 rent their residences4
  • National vacancy rate: ~7%5

Becoming a Landlord

Before we go further, it’s important to ask yourself if you’re comfortable with becoming a landlord. This means a brave new world of lease agreements, getting cozy with landlord-tenant laws in your state, property taxes, insurance, utility payments, and even the potential for the dark side of rental property — evictions. You’re also on call 24/7 and can’t exactly disappear or turn off your phone for a week. What if a pipe breaks and the residence floods?

If you buy property very close to your own home or live in a duplex and rent out the other unit, it may make sense to deal with tenants directly. But in other cases, you may want to enlist in the services of a property manager.

Do I Need a Property Manager?

If your rental property is far from where you hang your hat, it may be in your best interest to hire a property manager. For a monthly fee, managers act as your representative and usually deal with rent collection, maintenance, tenant interactions, and possibly more depending on your agreement. This doesn’t mean you’ll be fully removed from everything to do with your rental, as your property manager may need to contact you for updates and requests pretty often. For more information about the property management process, watch this video:

Rental Property 101: What to Look For

Profit is an overarching factor when searching for rental property. While we’ll discuss profitability below, there are other factors that you must consider while on your quest.

Price. The price of the home is an overarching factor when deciding whether to invest in rental property. If you’re a first-time investor, it’s generally recommended to look for properties well within your comfort zone. A starter investment property is usually in the $150K mark, but in many areas, this number is an impossible target. If so, you may have to broaden your search. Moreover, all budgets are different and should be measured accordingly.

Location. The location of your home is a big factor in determining what you can charge for rent. But the location is also a window into the future. By accessing websites like citydata.com, you can review the population, job and income statistics, crime rate, and anything else that might destabilize or add value to the investment property.

Rent Rates. The price of a property might be fairly low, which could directly translate to lower rents. But more expensive locations may not harvest the rental income that you would necessarily expect. Look in more than a few locations and diligently research the rent rates for the type of home or building that you’re looking to buy. Explore these resources for rent research:

Taxes/Insurance. Property taxes are all over the map in different states and counties, and the slightest percentage increase can sometimes make the difference in paying thousands of dollars more per year. When estimating property tax rates, be sure to look deep into county rules, because the tax rate might not be fixed, either — meaning the rate could increase depending upon the price of the property. Insurance is more straightforward, but quotes should be obtained from multiple companies.

Profitability. Let’s not beat around the bush — your aim is to pocket some cash. To do that, you need to look at profitability from all angles. After adding up the rent you’ll make, subtract 

  • utilities; 
  • vacancy rates;
  • mortgage payments;
  • property taxes;
  • property management fees;
  • lawn care;
  • snow removal; and 
  • anything else that will chip away at income. 

Investment Basics & Terms (Money Stuff)

Cash Flow. Some investors buy up old properties and beautify them so they can flip the property and sell it for a much higher price. But with rental property that you keep, the aim is to have monthly income — and specifically, a cash-flow positive property. Cash flow positive means that after each and every expense, you have money left over in the bank. The more cash flow positive a property is, the more profitable your rental will be.

Paying Cash vs. Getting a Mortgage. If you have the means, paying cash for a property might be the way to go, but remember to not put all your eggs into one basket — meaning, don’t use every penny you have to buy your first investment property. Why? Because you may have unforeseen expenses that pop up, like minor (or even major) repairs after your purchase. And yes, getting a mortgage means that you’ll be paying a ton of money in interest, but mortgages do exist to make purchasing procurable for people that don’t have hoards of money. When comparing mortgage companies, look at the following:

  • Interest rates
  • The length of the mortgage
  • What you’ll pay for the life of the mortgage
  • Hidden penalties

Down Payment. If you’ve decided that a mortgage is your best bet, you’ll need a sizable downpayment in order to avoid PMI — private mortgage insurance. Private mortgage insurance is an extra monthly charge for anything less than 20% down on a conventional loan. But investment property is a little different. Lenders usually require a minimum of 25% down for rental properties that have 2-4 units. Investors may not need to shell out as much for single-family homes.

Prequalification. If you’re getting a mortgage, you might have a general idea as to how much home you can buy. But after going through the vetting process, some investors are faced with unpleasant surprises and don’t qualify for as much as they expected. Getting prequalified can sometimes happen in under 24 hours, and although a pre-qualification won’t tell you everything, it’s a great way to estimate how much purchasing power is really in your pocket. Try this prequalification calculator first!

Should I Invest in a Multi-Unit Property or a Single-Family Home?

In some areas, there could be advantages to investing in multi-unit properties like duplexes and triplexes over single-family homes. In other cases, the opposite is true. Let’s go over a few examples.

Scenario 1: In one particular town, you may have found a great duplex with two one-bedroom, one-bath apartments for $125,000. In the same town, there’s a two-bedroom, two-bath, single-family home with similar square footage selling for the same price. Both were built in the same year, and while the duplex will make $700 for each unit — so a total of $1,400 — the single-family will rent for $1,500. The single-family makes sense, right? 

Not exactly. In this particular town, the vacancy rate is fairly high. If one unit of your duplex is vacant for 2 months out of the year, you’d still collect 92% out of your maximum possible rent. But if your single-family home is vacant for 2 months, you’d be losing more money. There are ways to keep your vacancy rates low, and the demand for single-family homes may be higher in certain areas, but sometimes, it’s simply the luck of the draw. Other times, you get lucky with great long-term tenants!

Scenario 2: In another instance in the same town, a different duplex has connected utilities. In the county, there’s an ordinance stating that utilities aren’t allowed to be estimated and charged to tenants if two units share a meter. The total for the connected meters for water and heat per month is $350 — which comes straight out of your profits.

You can pay to have the utilities separated, which may be better in the long run — but be prepared to pony up a few thousand dollars. 

There are other factors to consider, such as extra management fees if you’re having your property managed. Another thing to note is turnover rates, which may be higher in duplexes, as well as having to deal with more tenants, and potentially, more issues. But it’s not so cut and dry — you may find that in either instance, you may find perfect long-term tenants, which is every landlord’s dream.

Vacation Rental vs. Standard Rental

Another decision new investment owners must evaluate is whether they want to test out the short term rental market or keep their unit as a standard rental. Sometimes, short-term rentals on hosting platforms like Airbnb or VRBO can bring in more income in a week than traditional rentals would see in a month. But the STR market can be a challenging one to navigate — and some counties have even banned short-term rentals altogether. 

Let’s take a look at the pros and cons of both short-term (vacation) and long-term rentals:

Benefits of Short Term Rentals

  • More income — STRs often bring in a higher nightly rate
  • Personal use — owners may block days and use their property at their leisure
  • Cleaning fees charged to guests
  • Low service fees for owners on popular platforms
  • Tax write off advantages

Disadvantages of Short-Term Rentals

  • Income can vary or may be seasonal
  • Utilities and regular maintenance all paid by owner
  • Management fees or the need for constant interaction and communication with guests
  • Property must be furnished
  • Some areas have completely banned STRs or charge high city or county taxes

Benefits of Long-Term Rentals

  • Consistent income
  • Utilities usually paid by tenant
  • Less communication
  • Tax write off advantages

Disadvantages of Long-Term Rentals

  • Potential for less income
  • Unable to use the property
  • Always potential for bad tenants or evictions

Up for Debate:

  • Wear and tear. Though some people claim that short term rentals incur less wear and tear on the property, the opposite can be true, especially if you have a busy rental. STR owners all have a horror story or two about broken furniture, a mess, or way more people staying in the home than allowed. Long-term rentals can suffer a lot of wear and tear, too, but tenants are generally fearful of the owner keeping their security deposit, whereas AirBnB customers generally only have to fear a negative review from the owner.

If you decide to use your property as a short term rental, use the following pro tips:

  1. Do a market analysis. Websites like AirDNA give a full analysis of cities and can help you decide whether there’s a rental demand in the area — as well as an overview of your competition.
  2. Weigh management services. Most property management companies for short-term rentals charge a higher rate than those for standard rentals because of the level of involvement. If you’re far from your rental, you may elect to hire a property manager, but be prepared to say goodbye to around 20% of your profits.
  3. Hire the best cleaning crew. If you decide to manage the property yourself, you’ll want to have a few people in the area that you can really depend on — the most important of the bunch being your cleaning crew.

When you finally purchase your investment property, head to our 7-step guide that all landlords should read about how to quickly rent out your property to great tenants!

Sources

  1. https://ipropertymanagement.com/research/renting-statistics
  2. https://fortune.com/2017/12/28/us-rent-rates-zillow-2017/
  3. https://www.nreionline.com/single-family-housing/single-family-rental-housing-tenant-king
  4. https://www.pewresearch.org/fact-tank/2017/07/19/more-u-s-households-are-renting-than-at-any-point-in-50-years/
  5. https://fred.stlouisfed.org/series/RRVRUSQ156N

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