Image of a landlord showing prospective tenants a rental property.

Tips for First-Time Rental Property Buyers

Updated January 1, 1 . AmFam Team

Buying a second piece of real estate as a rental property can be a big task. Take a look at these new landlord tips to help you prepare financially and determine where to buy.

If a new home is the largest investment you’ll ever make, purchasing a rental property isn’t far behind. You’ve worked hard to get where you are today and the truth is, taking on a second mortgage is a big task. Once you’ve built up your deposit for the loan — which can be substantially higher than the deposit for your first home — there’s so much to consider before signing on the dotted line.

Among all of the financial decisions that investing in real estate involves, figuring out exactly where to buy a house to rent out is key. Take a look at the factors that go into deciding where you should buy your first rental property so that you’re making an informed financial decision. In order to get the biggest return on your investment, you’ll need to take into account the market conditions of your target neighborhood as well.

How Do You Know When You’re Ready To Buy a Rental Property?

Before you decide on where to buy, you need to know if you’re ready to buy. Here are a few financial factors to keep in mind that can indicate you’re in a position to buy a rental property.

Be ready to put down at least 20 percent. If you’ve already purchased a home, your minimum down payment was likely somewhere between 3-5 percent depending on a number of factors. But that’s not typically the case when it comes to buying a second home or a rental property. Mortgage lenders are likely going to require a deposit of at least 20 percent of the purchase price. That’s because private mortgage insurance isn’t allowed for second homes as they’re considered investment properties. So it’s important that you’re saving money to meet that requirement.

Prove positive cash flow before you buy a property. Now that you’re going to be responsible for two mortgage payments, lenders will be looking for a history of positive cash flow from your bank accounts. Be ready to deliver bank statements that help to prove your long-term finances are in order and able to carry a second mortgage. Keeping your closing costs to a minimum by requesting the seller carry some of your fees can also assist you in holding onto cash that you can retain to help your cause.

Expect a higher interest rate. Loans for second homes will usually come with a higher interest rate than those offered for a primary residence. You may need to fold that extra expense into the rental price in order to make the loan work.

What’s the Best Way to Pick a Location for a Rental Property?

There’s so much consider when deciding where to purchase an investment property. You’ve got to up your property manager skills, for starters. And it’s also time to think carefully about the neighborhood you’re choosing. Setting yourself up for success also means aligning with a real estate expert, too. So before you start the buying process, consider signing with a trustworthy real estate agent that can help you make an informed decision.

Decide on a property type. Single-family homes are a type of property that many first-time rental property purchasers aim towards because they’re likely to require less maintenance. This means that you’ll likely be able to convert more of your gross rent into profits than you would with a multi-unit property.

Get in front of a real estate agent. It’s a good idea to meet with several real estate agents before you decide to go with one. You may find that certain groups are better connected to rental property opportunities than others. Leverage their existing network to help you find a great spot. Often their insider information can steer you to consider a residence that has yet to go on the market. And if the homes are selling quickly in your target area, you’re going to want to be an early bird.

Look at recent real estate investors’ purchasing trends. It’s important to invest in a neighborhood where home prices are trending upward. This way, you’ll increase the odds of that trend continuing and maybe even gain equity on the purchase year after year, as property values increase. This will only increase your resale value as you collect monthly rent and pay down your mortgage.

Look at your purchase through the lens of a landlord. Will this property and neighborhood attract the type of tenant that will be able to afford the rent? Will they be good tenants and agree to get renters insurance while also taking good care of your home? Often, a well-kept neighborhood attracts more respectful tenants.

Estimate your rental income before you buy a home. Once you’re ready to buy, consider your ideal financial situation. Look at the amount you’ll be receiving in rent and then deduct the mortgage’s monthly payment, property taxes, assessments and landlord insurance. Take a look at rental listings on Zillow and Craigslist and plug in your home’s particulars like zip code, square footage, amenities and number of bedrooms to be sure your home will be able to generate the amount of income required for it to be a profitable investment.

Consider upgrade and maintenance costs now. Will your rental income be enough to cover expenses that may be needed to get it into a rentable condition? If your budget’s too tight, you may find yourself unable to turn a profit in the months ahead. Perhaps the roof’s going to need replacement soon, remember to factor that expense into your decision. And it’s important to anticipate upkeep costs like plumbing and electrical repairs as well. So put together a team of expert contractors that can help you maintain your rental home if it should need some work.

Hopefully you’ve now got a better idea of what it’s going to take to make that final decision on when and where to buy. While you’re getting these details organized and considering your financial options, remember to check in with your American Family Insurance agent (Opens in a new tab) to learn about our Landlord Toolbox. It’s a great resource for new and veteran investment property owners, full of useful information and great ideas.

 

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    Start with the “One Percent Rule”

    Answer a simple question: Will your monthly rent for the space equal at least one percent of the purchase price? If your answer is yes, then your place may be able to turn a profit in the years ahead. Congrats, you’re off to a good start. Be sure that the rental’s priced competitively for spaces of similar design. Here are few other factors to consider:

    Understand the formula

    If the total purchase price of the property is $200,000, rent should be no less than $2,000 per month or one percent of the total cost. Likewise, a $600,000 purchase price for a multi-unit rental property should meet or exceed $6,000 per month in total monthly rent earnings.

    Get the purchase price right

    When factoring in the purchase price, remember to include closing costs, property taxes and insurance. One way to better estimate these costs is to use an online closing costs calculator which can approximate appraisal fees, home inspection fees, application fees, prepaid interest among a host of other out-of-pocket expenses that can up your purchase price, sometimes by thousands.

    Factor in repair costs now

    Because real estate investing as a landlord requires the space to be “habitable” upon tenant occupancy, you may need to make certain repairs or upgrades before renting the property. As a result, you’ll want to add the total cost of these repairs into the purchase price.

    Consider the “Class” of the Neighborhood

    Neighborhood classifications help buyers understand the potential return on investment in a given area. If you’re new to being a landlord, you’ve got to pay close attention to what the neighborhood’s telling you.

    One good way to check out an area — specifically if it’s an investment that requires some traveling — is to use Google map’s street view. Is trash left out on the front lawn? Do neighbors maintain their property? What can the cars parked on the street tell you about the demographic? Here are details on the four distinct neighborhood classes real estate agents use to classify a region:

    Class A neighborhoods

    High income neighborhoods, combined with a home that is move-in ready will usually get an A class rating. Because homes are expensive in these neighborhoods, and their higher than average tax burden, real estate investors usually won’t buy a home there because the one percent rule fails the test. Tenants in these areas tend to be very reliable, high-quality renters.

    Class B neighborhoods

    Typically populated by those earning a moderate-to-high income, B class neighborhoods are frequently considered a good investment for landlords and fertile ground for tenants seeking rentals. Purchasing “as is” properties that can be cheaply updated and rented above the one percent factor is typically possible here with minimal risk. These areas will usually experience increased turnover and vacancy rates.

    Class C neighborhoods

    Because the risk is a little higher in neighborhoods that land in the C class category, the opportunity to see a high rate of return on fixer-upper places is good if you buy a For Sale by Owner property, or one not listed on the MLS (multi-listing service for real estate sales). Populated with blue collar workers with relatively low-to-average income, C class areas typically have higher crime rates and under-performing schools. Landlords should expect less-than-optimal tenants and periods of vacancy.

    Class D neighborhoods

    Areas riddled with crime, properties damaged upon a tenant’s exit and high costs for property upkeep can be anticipated in D class neighborhoods. Buyers usually consider these types of purchases high risk. It should be noted that many property management companies are reluctant to accept properties to service in these areas because the risks associated with the area. Investors tend to seek properties in more stable neighborhoods.

    Use the Capitalization Rate as a Predictor of Value

    Another key way of understanding the rate of return on an investment is the capitalization rate or “cap rate” for short.

    What is a cap rate?

    A cap rate determines a profit ratio that a property can generate. It’s best used as a quick way to compare investment opportunities to determine which one is the better value. Start by dividing the total of one year’s rent by the current market value of the home which should include costs and upgrades required to get the space habitable — you can’t rent the place if it’s not livable, right? The resulting percentage is your cap rate. The higher the rate, the better your annual profit margin.

    How to Calculate the Cap Rate for an Investment Property

    Although the cap rate’s a useful tool to quickly analyze the relative value of comparable real estate opportunities, it’s used as a rough guide to qualify properties for consideration, given the state of today’s current market climate. First, estimate your property’s overall purchase price:

    Figure the acquisition value

    Simply put, this is the total purchase price. It should include all upgrade costs, closing costs, taxes, business insurance, fees, points, etc. Let’s assume a property you’re considering has a total purchase value of $200,000.

    Calculate one year’s rent

    If you’re collecting $2,000 per month, you’ll have twelve payments at the end of the year, or $24,000. This figure is your gross annual income.

    Account for half a month’s vacancy

    Because turnover typically requires some painting and repairs, it’s fair to consider that half a percent (two weeks’ worth of rent) of your total annual income will be deducted to cover the mortgage payments. Assume that your new tenant will cover the remaining pro-rated rent for the other half of that month. Once the vacancy amount is deducted, the result is your gross operating income.

    • Gross annual rental income: $24,000
    • Less the cost of vacancy: -$1,000
    • Gross operating income: $23,000

    Factor in operational costs

    These costs will include money required to keep the property habitable, like paying for trash collection, making repairs, fees from property management, and landlord insurance. Let’s put that cost under fifty percent of the gross operating income, or $9,300. Some years it will be more, some less.

    • Gross operating income: $23,000
    • Less operating costs: $9,300
    • Net operating income (NOI): $13,700

    Divide the NOI by the total value of the property:

        $13,700 
    ---------------------  =  0.0685 or 6.85 % - That's your cap rate.
       $200,000 

    The capitalization rate for this investment is 6.85 percent annually. If another property under consideration returns a higher cap rate like 8.23 percent for instance, you may want to explore opportunity with the higher annual yield in order to maximize your profit potential.

    What is considered a good cap rate?

    Generally, a cap rate between 8% and 12% is considered good. However, an optimal cap rate is really going to depend on several factors including location, risk and current rental income. For example, in high-demand like big cities, a cap rate of 4% may be considered good.

    Reach Out to Your Agent Today

    With so many different ways to look at profitability when determining where to invest in rental property, it’s important you do your homework before you decide to buy. And while you’re making that big decision, remember to contact your American Family Insurance agent and discuss your upcoming purchase. When it comes time to close the deal, you’ll have peace of mind that your property’s insured carefully.

    This article is for informational purposes only and includes information widely available through different sources.

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