Introduction
A rental property investment may not be for everyone as it involves considerably large up front costs in the form of a down payment etc. But once you have set aside some money, a rental property becomes a worthy option to consider as a semi-passive income stream. Mind you, this isn’t a passive income source that you can leave on auto-pilot and expect cash to roll in. Especially in the beginning where you procure your first investment property and get your first tenant. You should prepare yourself mentally to receive the dreaded call in the middle of the night with the tenant on the other line complaining about clogged plumbing.
Having said that, if you do your homework and prepare for the journey, the reward of owning a rental property and real estate investment is tremendous. Not only does it provide you with a predictable source of income but it also appreciates in value over the years. It grows equity as you pay down your debt and the expenses incurred for the upkeep of your property are tax deductible.
Getting Started with Rental Property Investment
So how do you get into owning a piece of this pie? There are a number of things you need to start thinking about if you want to pursue this path. First and foremost, depending on where you are located and the lenders you are dealing with, you will need to have anywhere between 15 – 20% of the property value in cash to put down as a down payment. So right off the bat, you need to start researching properties in your area that you would consider investing in, to assess the market and figure out how much you’d have to save to bring to the table.
Another thing you can start working on in parallel with saving up for a down payment, is to start working on your credit score. It’s near impossible to secure ideal interest rates on a mortgage loan from banks if your credit score is lower than 760. You can begin optimizing your credit score by making sure that you have a few active credit lines which you pay off on time. Keep in mind that improving credit scores can take time and therefore if yours needs improvement, you must begin working on this immediately. Look for posts about how to improve your credit score and how to start building your credit from scratch.
Securing a Mortgage
Your next step would be to get your paperwork in order to shop around for a mortgage loan. And it’s crucial to shop around for the cheapest loan with the best terms. Don’t settle on the first lender that you speak with. You will find that doing extra due diligence here will pay dividends in the long run. In terms of paperwork, the lenders would like to see:
- Most recent tax return documents (in some cases they might even request the previous 2 years).
- Recent pay stubs.
- Bank statements to see your income vs liabilities.
- Your credit score.
The better prepared you are to provide the prospective lenders with this information, the smoother the process would be. Keep in mind that a ‘hard’ credit inquiry has a small but detrimental effect on your score.
Since shopping around for a favorable lender might take some time, it’s best to do a free ‘soft’ credit check yourself and have that score handy. This score, though not a hard and final one, should give the lenders enough to run the numbers for you and give you an estimate of your loan qualifications. There are several free services available that offer a free credit check. Some of these include Credit Sesame, Experian etc.
Once you have figured out which lender you want to work with, find out how much loan you can qualify for and get a pre-approval letter. This is a vital step in a competitive real estate market because when a property becomes available, it’s usually the most prepared buyer whose offer is entertained. Think about it from the buyers perspective. Most buyers are looking to get their money with the least amount of headaches and a smooth sale transaction. To ensure that, usually someone with a pre-approval letter from a bank backing up their offer is given precedence over someone without one.
Property Search
After lining everything up it’s time for you to go out and start looking at the potential investment properties. It’s vital to look at more than one property and recommended that you begin searching while getting your financing in order. Keep an eye on local listings by checking out local Real Estate websites. Zillow and Redfin for example, are great platforms. Especially keep an eye out for open houses and make it a point to attend as many as you possibly can. You don’t need a real estate agent to represent you and you can simply walk in to have a look at the properties. This will give you an idea of what’s out there in the market and once you have your financing in order you will also know what you can afford.
Having done this homework in advance will ensure that you don’t jump on the first property that you come across. Start collecting data on what’s the going price per square footage in the area and start getting the feel for the floor plans, layouts, designs, fit and finishes. Having accumulated this knowledge will put you in a better position to identify a good opportunity once it arises.
Things to look for
Some of the things that you should look for when inspecting properties are:
A) the area where the property is situated. One of the best things to do is to look at the school ratings in the area. The higher the ratings, the likelier the chance that the area has lower crime rate and has other attractive perks.
B) Look for properties away from main roads and intersections to avoid road noise since that’s something you won’t be able to fix once you have acquired the property.
C) Look for homes with hardwood or laminate floors over carpeted homes. It is highly likely that you will end up having to replace the carpet after the departure of every tenant. Overtime, this will eat into your profits and add to your annual costs.
ROI Calculations
Aside from looking at the property and assessing its condition, part of the homework also requires that you do some number crunching to see if the acquisition of the property is financially viable. The first thing that you would need to do is to see how much income you could potentially generate from this property.
Rental income may be the most obvious source of revenue in this case but there are other things to consider as well, such as a coin operated laundry on the premise or extra storage etc. You can get these approximates from either the seller (if they are also using the property as a rental property), from the sellers agent, or by doing some research on your own by checking to see how much similar properties are being listed for rent in the area. Add to this the equity portion of the monthly payment you will be making towards the mortgage loan.
Once you have figured out your expected monthly income, tally up your monthly expenses. Add up obvious things like the mortgage, property taxes, insurance and HOA/Condo fees. And not so obvious things like provisions for unexpected repairs, vacancy and capital expenditures which are funds set aside to deal with bigger maintenance related expenses such as roof repairs etc. Depending on whether you want your tenants to pay for the utilities or not, you’d have to make provisions for those here as well. Although, we recommend that you write it up in your rental agreement as a tenant’s responsibility. This will ensure that they don’t abuse the utilities and stick you with the bill.
Now that you have your rental income and expenses calculated, you subtract your expenses from your income to get your cash flow. At this point, you obviously hope that this cash flow value is positive. But you want to take it one step further and determine the cash on cash return on your potential rental property investment. To determine this, you need to calculate how much you’d be spending to acquire this property. That calculation will include adding up the down payment that you will be making, your closing costs (these are activities that are needed to process the transaction such as the title fees, flood insurance, loan origination fees etc), cost of any work that you’ll need to do on the property to make it habitable before a tenant moves in, etc.
Now to calculate the cash on cash return on investment, you take your expected annual income (multiply the monthly income that you calculated earlier, by 12) and then divide it by the cost of acquiring the property. The number you will get is the percentage cash on cash return value of your investment. Now to determine whether this is a value that makes this a worthwhile investment, you need to compare this number to the average return offered by other investment vehicles in the market at the time of property acquisition.
If there are other less riskier and profitable investment options available then you are better off investing your money there rather than in the property, however, the stability offered by a recurring rental income stream is usually enough to offset the slight upper hand that stock market trading often has in terms of return on investment. What makes a rental property investment even more of a lucrative option is the fact that the property often appreciates in value and also the rents usually go up a few percentage points with each passing year so your return on investment value only stands to improve.
Property Inspection
Once you have narrowed down a property, make sure to have it inspected by a professional. Look for a good property inspector. Usually you can find them by looking them up on Yelp. It’s vital to get an inspector who is going to be thorough in their inspection. Their job is to look at structural defects, electrical, plumbing, roofing, sewers conditions, radon tests and every other thing imaginable. The more thorough the inspection, the more informed of a decision you will be able to make regarding whether to sink your hard earned/saved money into a particular rental property for investment or not. Having said that, it’s not necessary to reject a property based on the list of issues found. You can in fact use these issues to either negotiate the price down or get the seller to fix the issues prior to purchasing the property.
Finding a Tenant
Once the transaction is done and you have acquired your rental property for investment, then it comes time to take good pictures of the property in order to post your vacancy ad. Nowadays, smart phones are equipped with really good cameras and with some artistic inspiration that you can get looking at real estate websites and some good lighting, you can take some really good pictures yourself. This is something we recommend you do if your rental property is in a very hot market where the demand is high and supply is low. It’s likely that you will be able to find a tenant without having to dish out money from your pocket to get professional photographs taken of the property.
If you are however not a good photographer or if the property is in an area where tenants are hard to come by, then it’s recommended that you hire a professional for taking photos. Make sure to save these pictures so you can reuse them down the road (so long as you don’t make cosmetic upgrades to the house after the pictures are taken). To advertise the property, use online free classifieds like Craigslist and Facebook Marketplace etc to post pictures and description of the property.
It is also important to keep in mind that how you write up the vacancy ad also makes a difference. Make sure to keep the prospective tenant in mind while writing the ad. A young student might be interested in proximity to public transportation and happening locations in town along with closeness to schools and groceries. Whereas a young couple may be interested in the quietness of the neighborhood, quality of schools in the area etc. You would want to highlight these qualities of the property in your ad. If you got em, make sure to point out big items like views, open concept layout, stainless steel appliances, granite counters, hardwood floors, air conditioning etc.
Screening a Tenant
At this stage, hopefully your phone has started to ring or your inbox has started to receive some messages. When that happens, you must be able to showcase the properties to the prospective tenants as soon as possible without delays as you don’t want them to lose interest. You may also want to get ready to run background checks on these tenants. There are several online services available that allow you to do that such as Rent Prep, My Rental and Smart Move.
You can even write up your lease agreement such that you get the tenant to cover the costs of the background check as a non-refundable fee. These services can give a very decent idea of the type of applicant you are dealing with as they include their credit history, eviction reports, bankruptcy records and even criminal background. Based on these reports, you can make a more informed decision about whom you hand over the keys to your property to.
Wrapping it up
The last thing left to be done once you have selected a tenant, is getting the paperwork done. If applicable, make sure to provide the tenant a copy of condo rules and regulations etc as well as go over the terms and conditions in the lease agreement and answer any questions that they may have. You can find a template for a lease agreement by doing a quick google search and amend it to suit your needs. Make sure to iron out the details of how you will be collecting that monthly rental payment (direct deposit, mail in check, Venmo transfer etc) in the lease agreement and that would pretty much wrap up your first source of an income generating rental property set up.
If you are looking for more ideas to increase passive income or learn about investment, make sure to check out the rest of the blog posts here here for many more tips and tricks to improve your financial outlook.