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How to Buy a Rental Property

FinanceBuzz
FinanceBuzz
 2022-12-07
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Buying a rental property is a complicated process. You’ll need to figure out how much you can afford to pay, how big your down payment should be, whether you’ll need a mortgage, and which lender has the right terms for you.

After all that research and due diligence, you’ll still need to meet lender requirements, such as income potential, creditworthiness, and property safety before you can even think about undergoing the formal closing process. There's a lot that goes into the process before you begin investing money.

Despite the daunting process, owning rental properties typically pays off. From 2020 to 2040, there’s expected to be 9.3 million more renters in the U.S. (a 21% increase) according to “The Future of Headship and Homeownership” report from the Urban Institute. With such potential demand, it could be an ideal investment opportunity to learn how to buy a rental as an investment property.

How to buy your first rental property

Unless you have quite a high cash flow, you’ll probably need a mortgage loan for your first time buying rental property. The process of securing a loan for an investment property is a bit more complex than a traditional mortgage loan. You’ll need to research lenders and gather some information to get started.

Finding a lender

Prior to finding the ideal rental property to purchase, you need to consider the requirements for ownership. Each lender sets its own terms and conditions, and there could be significant differences between them. Some may have far stricter requirements for rental property borrowers than for individuals buying a home for themselves.

Regardless of each lender’s specific requirements, you can generally expect all lenders to require the same basic information to get started.

You can expect rental property lenders to require the following:

  • Credit score: Although lenders adhere to different credit score ranges, a credit score of at least 620 is often a requirement for property loans. A higher credit score may get you better interest rates and terms without having to refinance down the road.
  • Down payment percentage: A larger down payment may be necessary for rental properties specifically. It’s not uncommon to have to pay a 25% down payment upfront on an investment property.
  • Available cash flow: Many property owners cover their mortgage payments with rental income, but you may not always have paying renters. That’s why some lenders require borrowers to have a significant amount of savings on hand that could cover the loan payment for three to six months — or sometimes longer.
  • Income: Borrowers need to show that they have enough income coming in to meet their payment obligations, regardless of what income they expect to earn from the rental property.

Lenders may require documentation to verify the information you give on the application. They may also ask you about expenses, other forms of debt you carry, and what experience you have in rental property management. If you want to dig deeper into how to invest in real estate, it will help to have a good relationship with a lender.

Finding a potential rental property

If you’ve started the financing process and have your eye on a home or other property, work through the following steps.

1. Get to know the community

Walk through the community to get an idea of what life is like in that neighborhood. Use Google Maps Street View to get another view of the area. Look at what the area has to offer, such as parks, walking distance to school, sidewalks, and access to retailers and restaurants.

Do some research on the school district through sources such as GreatSchools.org and Public School Review. All of this info gives you insight into how attractive the area will be for renters.

2. Get an idea of the affordability

A real estate agent may be helpful during this process. They may be able to help you know how rent-dense the community is, which could give you insight into the desirability of the area.

They can also run a sales comparison for you, so you can see the value of your desired rental property compared to other properties that sold recently. This helps you to know if the property you’re interested in is a good purchase price.

3. Determine market rents

You need to determine how much you can expect in rental income based on what other renters are paying in the area, as well as multiple other factors. Your real estate agent can help with this as well.

Part of estimating rental income includes calculating the cap rate, which is your net operating income divided by the current fair market property value.

In other words, the cap rate is the total amount of money you will receive each month in rent, minus any operating expenses, such as repairs, updates, and property taxes. A higher cap rate means a higher potential to earn profit from your property.

4. Do your homework

Next, get insight into any permits you may need for operating a rental within the community. Some areas may have specific limitations on how many people can be in the home, as well as setback regulations. The best resource for this is the local city government or the city building department.

Financing a rental property

Getting a loan for a rental property means obtaining a non-owner-occupied loan. That means you, as the owner, will not live in the home. But there are other types of loans as well that you may qualify for if you plan to live in the building. Some types of loans that could be used for rental properties include:

  • Conventional loans: Also called conforming loans, they come from traditional banks and credit unions and typically have higher credit score requirements with competitive interest rates.
  • FHA loans: For borrowers who will be living in one of the units in the rental property, such as in a duplex, a Federal Housing Administration (FHA) multifamily loan may be an option. It offers lower down payment and credit requirements.
  • VA loans: Multifamily Veteran’s Affairs loans are an option for those who have served in the U.S. Armed Forces. These loans have lower credit score requirements and no minimum down payments, but borrowers must live in one of the units of the property as a primary residence.

Fannie Mae and Freddie Mac offer non-owner-occupied rental property loans, which are accessible through many banks and credit unions.

4 Things to keep in mind when buying a rental property

A rental home buyer needs to learn how to buy a rental property confidently, which means gathering as much information as possible. Here are some key factors to keep in mind.

1. Recognize that you need tenants in order to have passive income

A real risk to owning rental property is that you may not have paying tenants at all times. Even without paying tenants, you remain financially responsible for all costs of your rental property, including mortgage payments, taxes, utilities, renovations, and homeowners insurance.

This can be an even bigger problem if you ever face depreciation, or if you have to issue an eviction for non-payment (or other reasons).

2. Determine if you would benefit from a property manager

Even with a single family rental property, you may benefit from using a property manager. Though this is an extra cost, these professionals know the local rental industry well and can help with various tasks.

Such tasks may include screening tenants, managing tenant needs, marketing the property, and keeping renters satisfied so that they stay longer. When calculating the potential profit from a property, factor in the cost of using a property manager.

3. Have a strategy in mind

Do you plan to purchase and maintain the rental property long term? Perhaps you want to add properties to your portfolio for ongoing growth. You may want to consider the BRRR method, a process of buying, rehabbing, renting, refinancing, and then repeating the process. The key here is to have a goal about how you want to approach rental property ownership.

4. Think about your long-term needs for credit

All properties eventually need repairs, which can mean anything from a new roof to new carpet. As a property owner, it’s up to you to have accessible funds you can use to pay for problems as they arise and ensure the property remains safe for your tenants. If you can’t always pay for repairs out of pocket, then you’ll need to have options for credit, such as a HELOC or home equity loan.

Compare a HELOC vs. home equity loan to have access to equity to help with property repairs. If you decide to use credit cards for real estate investment, be sure to factor in the interest rate and other fees into the cost of owning and managing your property.

Is owning a rental property worth it?

As with all investments, investing in a rental property comes with numerous risks. There’s no guarantee you’ll earn a reliable income that’s enough to cover your expenses. And not everyone is cut out to manage property for tenants. But for the right person, a rental property could be a good investment.

You may be a good fit for owning rental property if:

  • You qualify for an affordable loan on the property you want.
  • There’s ample room in your budget for making payments, even if you don’t have a tenant.
  • You know the area well and can gauge real estate market conditions, or you have access to a realtor who can help.
  • There’s enough time in your day to manage tenant needs, or you plan to hire a professional to do so.
  • You can handle repairs and troubleshoot problems as they occur, or you can pay someone to do that for you.

You may not be a good fit for owning rental property if:

  • You don’t like working with other people and may not do well dealing with difficult tenants.
  • You have an unstable budget that could put you at risk of defaulting on a mortgage loan. (This could severely impact your credit score.)
  • You’re worried your target area isn’t a good fit for rental properties, or there are rising taxes and insurance costs in the area that you can’t afford.
  • You need to have quick access to your investment funds, as rental property investing is not a liquid asset.
  • You don’t have a strong credit history and can’t get good mortgage loan rates.

FAQs about buying a rental property

How much profit should you make on a rental property?

How much profit you make on a rental property is often specific to the area your property is in and how much you’re able to charge tenants for monthly rent (plus a one-time security deposit). In general, if you can rent a property for 1% of the purchase cost, then that may be enough for a healthy return on investment.

What are the disadvantages of owning rental property?

Rental properties are not liquid assets, which means your money is tied up in them until you can sell. You also may have to deal with rising costs in insurance, taxes, and overall utilities, and that could tap into your profits if you don’t increase rent. There’s also the need to deal with tenants, who can be unpredictable.

How does the IRS know if I have rental income?

It’s a legal requirement that you report all income from your rental property to the IRS. Not doing so could lead to fines. The IRS may learn about your rental income from a tax audit, public record information, or even reports from someone who informs them.

Bottom line

Making the decision to purchase rental property can be a big one, but it also provides an opportunity for individuals to invest in real estate. Take the time to learn as much as you can about the process, and talk to locals who are already rental property owners to get a better idea of what to expect.

Be sure to read more about getting started in real estate investing.

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