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8 Steps To Take Before Buying Your First Rental Property

8 Steps To Take Before Buying Your First Rental Property

April 30, 2018
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So maybe you're on your Haverfordian-search to find your next investment opportunity, and you've landed on the rental real estate market. We've covered stocks, bonds, and mutual funds in the past, but many people are just as interested in becoming the next real estate mogul as they are at learning how to invest in the stock market. But buying rental properties is a move that shouldn't be done without significant research into pros and cons. If you're positioning yourself to buy your first rental, there are steps that you need to take to make sure you're protected from unneeded risk, and today we're here to cover them! Here are 8 ways to make sure you're ready to take the leap into landlording.

1. Prepare For A Big Down Payment

When you buy your primary residence, the percentage of your home's value that you bring to the table as a down payment is very important. With most lenders, bringing less than 20% as a down payment may allow you to get a mortgage, but also potentially adds things like Private Mortgage Insurance or Mortgage Insurance Premium to your payment. With investment properties, however, there are less variables to consider, as many lenders won't even let you get a mortgage on a rental property without a 20% down payment. Even if you find a lender that wants to be more lenient, some programs that allow you to get a mortgage with a lower down payment on an owner-occupied home, such as FHA loans, are not eligible for investment properties (there is a caveat for FHA loans in particular; if you use an FHA loan to buy a multifamily property such as a duplex and you live in one of the units, you might still be able to use FHA lending). Additionally, mortgage interest rates for investment properties are typically higher than what you'd qualify for if you actually lived in the house. So if you're crunching the numbers for your potential property using rates from your primary residence or what you believe are current rates, they may not be the most accurate. 

2. Prioritize Emergency Savings

Ideally, you'll buy a rental property and have a quality tenant in place before you even close. Then that tenant would stay there for 20 or 30 years, consistently renewing their lease, and the property never sits vacant or needs major repairs. The fact is, there will be times when a tenant leaves and it takes a few months to find a replacement, and you'll be covering the mortgage during those gaps. And as far as repairs go, HVAC units will break, toilets will clog, and the roof will need re-shingling. Having an amount of savings set aside for your rentals are imperative. A good goal to build towards is having a few months of the rental unit's expenses set aside ABOVE AND BEYOND the emergency savings for your primary home. That way, your home's finances won't be negatively impacted by an unexpected expense at your rental property.

3. Examine Your Cash Flow

When talking with clients interested in investment property, I often encourage them to only move forward if they can afford the payment on the home for a few months if need be. Yes, I know I just told you to put a few months of the property's expenses in savings, so paying for it out of pocket shouldn't be needed. But let me explain: if you're serious about rental properties, it's highly likely you're interested in purchasing more than one. In order to do so, you need to make sure you're attractive to a lender AFTER you purchase the property, and you do that by protecting your debt to income ratio. Even if you don't use your monthly income to pay the note in months where the home is vacant, the ability to do so is a good sign that you haven't bitten off more than you can chew. And once your rental has a stable tenant, it makes a lender more comfortable offering a mortgage for a second rental property. Setting this standard for your first property is a responsible way of making sure it's not your ONLY property! 

4. Find A Property Manager

Using a property manager for a rental is definitely personal preference. Property managers do things like locate and place tenants, handle complaints and repairs and, in worst-case scenarios, evictions. Some property managers charge a percentage of the monthly rent as their payment, while others charge a flat fee. You could certainly handle all of these things yourself, and that introduces a crucial decision you'll have to make as a landlord: do you want to do it yourself and save every dollar you can (active management), or take a haircut on your profit in exchange for less headaches (passive management). Speaking from experience, I hated actively managing the problems that popped up as a landlord, to the point it discouraged me from rentals period for a number of years. It not only takes a special temperament to be a landlord, but also the time and aptitude to deal with any issues that pop up. Even if you have two out of the three - for example, you have the aptitude and temperament to deal with repairs and complaints, but not the TIME needed to do so - you might still be better off researching property managers who can take the load off your back.

5. Dig Deeper On Property Taxes ...

Property taxes on your rental can be paid separately or lumped into your monthly mortgage payment. For primary residences and rentals, these taxes are often based on a percentage of your home's value as calculated by the property assessor. While there are often caps on how high those percentages can reach, the caps could be higher for rental properties in your area than what they allow for primary residences. Oftentimes listings for residential real estate have an estimate for property taxes that are based on that home being owner-occupied. Call the county tax assessor and ask how they view property taxes for investment property, and make sure your numbers are accurate when planning for your home's monthly expenses.

6. ... And Your Home Owners Association

The HOA to which your property belongs can be your best or worst nightmare. Annoying as it may sound, some of the standards HOAs impose on their community, such as requiring regular landscaping and restricting noise levels, can provide uniformity to the neighborhood and increase property values. On the other, there are HOAs that enforce rules that are cumbersome and lead to heavy fines. And keep in mind, you won't be the only one who is forced to keep these rules, your TENANTS will be as well. If you have an HOA with a laundry list of rules, it might be an added burden to monitor your tenants to make sure they're adhering to the regulations. Your HOA might even restrict the number of ways you can use the property, as many now forbid their members to list homes on AirBnB and VRBO. Additionally, the fees charged by your HOA and any increases on the horizon can eat into your profits as a landlord. Before you buy, ask for the last few years' history of HOA fees for your residence, as well as all reports detailing the HOA's financial condition. Any time the HOA covers any repairs or improvements to your community, those costs are shared by the members. When there aren't enough HOA funds to cover these costs, they can ask for a special assessment from the members, which essentially requires them to give a lump sum amount to cover the shortfall. For all of these reasons, it's important to know as much about your HOA as you possibly can!

7. Buy an Umbrella Policy

Some of the things you'll need on your house are pretty obvious, such as insurance to protect the home from damage. But if you're renting out a property, consider an umbrella policy as well. An umbrella policy, or a personal liability policy, is insurance that covers you in the event you are found to be personally liable for certain damages. For example, if your tenants were to sue you for an issue that is beyond the scope of what's covered by your homeowners insurance, an umbrella policy could help make up the difference. While these types of policies are valuable even with one rental property, investors interested in purchasing multiple rentals should definitely protect themselves against the threat of a lawsuit. Fortunately, umbrella policies are typically pretty cost-effective, and might be available at a discount through whichever property and casualty provider holds your home or auto policies.

8. Avoid The Fixer Upper 

It's important to determine your end-goal when dipping your toe into investment real estate: are you looking for quick cash, or do you prefer to have steady, recurring revenue? If you're looking for quick cash, it sounds like you might be a candidate for "flipping" houses, where you buy a property, invest money to increase its market value, and (hopefully) sell it for a profit. In my opinion, flipping houses with no experience is a risky way to get started. You have to either be handy enough to manage the repairs and upgrades yourself, or have relationships with contractors and be able to monitor the construction budget and timeline of the project, neither of which are easy to do. For these reasons, I believe starting with the goal of finding a property that can provide steady cash flow is a better bet for beginners. And when the goal is cash flow, it's less risky to find a property that only needs light work to be ready for tenants (e.g. new carpet or paint) than buying one in need of heavy repairs. If your thinking is that completing those repairs will do wonders for the home value, that's a flipper's mindset. Now you CAN be a landlord and also a house flipper at the same time, but not with the SAME HOUSE: pick one goal for your investment property and stick with it! 

I hope you found these tips useful as you start the search for your first investment property. Real estate can be an excellent addition to an investment portfolio, especially when managed responsibly. Do your research to make sure that the profit margins you're projecting actually line up with all of the information you have on the property. If they do and your finances are stable enough to handle the potential risks, you just might be well on your way to becoming the next real estate mogul! Happy home hunting!

Investment Advisor Representative/securities and investment advisory services offered through Signator Investors, Inc., Member FINRA, SIPC, and a Registered Investment Adviser, Henderson Financial Group is independent of Signator Investors, Inc., 5409 Maryland Way, Suite 300, Brentwood, TN 37027 (615) 386-9141