Everything You Need To Know Before Buying Rental Property
Miranda Crace6-minute read
August 01, 2022
Buying a rental property is a big decision with big financial implications. You’ll want to find a location that’s easy to rent and a property that fits your budget, and then figure out how you’ll pay for your new investment property before you can make an offer.
Though every property is different, the process of making smart property investment decisions is the same.
Let’s look at what you need to know when investing in a rental home, the different factors you’ll need to consider and what to look for when buying your first rental property.
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What You Need To Know Before Investing In Rental Property
Buying rental property differs from buying a house as a primary residence in that the end goal is to turn a profit. This means you’ll need to treat your investment as a business by choosing affordable properties and finding the right way to finance the purchase.
Before you buy an investment property, take the time to review your options and learn the ins and outs of what it takes to own rental property.
You’re Responsible For Everything
When you purchase a rental property, you’re in charge of buying a house (often a multifamily home), finding tenants and maintaining the property while collecting monthly rent and paying property taxes. When planned and well-executed, buying rental properties can be an investment that eventually becomes a source of real estate income and profit.
It’s important to consider what type of property you want to rent out. Different types of homes come with different responsibilities. For example, renting out a house with a lawn could involve more landscaping and lawn care than an apartment building in the city. However, buying a multifamily home or apartment building means you’ll have to find more tenants and maintain more rental units at once.
Pros And Cons Of Buying Rental Property
A crucial part of figuring out whether you want to start investing in rental properties is learning about the risks and rewards associated with your purchase.
Here’s what you can expect when you buy a rental property:
- Owning a rental property can be a source of passive income, meaning you can continue to work a regular job and earn rental income on top of your regular salary.
- Rising market values will also increase the value of your investment property.
- Rental income is not subject to Social Security taxes.
- Real estate is a relatively stable investment.
- You’re entitled to several tax deductions and benefits if you rent out your property for at least 14 days a year. You may be able to deduct the cost of repairs, insurance, mortgage interest, attorney’s fees, marketing expenses, property depreciation and other similar costs.
Consult a tax specialist if you’re not sure whether something’s deductible. Specific deductions vary by state and income level.
- You may have to work with difficult tenants.
- You won't be able to instantly sell your property if you need quick cash.
- Your success depends on finding tenants who can cover their rent, so you must advertise the property and find the right renters. In some cities, leasing to the wrong tenants can mean fines or legal trouble for you.
- You’re responsible for performing regular maintenance and repairs, such as keeping the home up to code, and overseeing lawn care and snow removal.
- You’re totally responsible for paying the bills. This includes not only the mortgage and taxes, but also homeowners insurance.
- Hiring a property manager to take care of your maintenance, rent collection, evictions and advertising can be costly.
- You might have to pay for larger down payments of 15% or higher, depending on the mortgage loan you’re using and the number of units being purchased.
Is Buying Rental Property A Smart Investment?
As a rental property owner and landlord, your main goal is to end each month with a positive cash flow. To understand if a rental house is a smart investment, you need to understand the costs involved and estimate your potential return on investment.
Here are a few of the costs you might be responsible for as the owner of a rental property:
- Maintenance costs
- Landlord insurance costs
- Property management premiums
- Property taxes
- Mortgage payments
The exact amount you’ll need to budget for maintenance depends on your area along with the age and condition of your rental property. Some experts recommend allocating 1% of the property’s value each year for maintenance.
When your tenants move in, you can require them to pay a security deposit. If they damage the property beyond normal wear and tear, you can keep the deposit and use it to pay for repairs.
Some damage is unavoidable. As a landlord, you’re usually responsible for damage caused by flooding, fire or other natural disasters and issues with major systems in the home (plumbing, electrical, heating and air conditioning).
Landlord insurance policies usually cover the property itself, any additional structures attached to the property (like a garage or mudroom) and any property inside the unit that belongs to the landlord. Some insurance policies may also cover lost rent or attorney fees if a tenant stops paying rent.
The price of your landlord insurance will depend upon your property’s value and your area. Generally, expect to pay 15 – 20% more for landlord insurance than a standard homeowners insurance policy.
Return On Investment (ROI)
Return on investment (ROI) is a way to understand how valuable your investment is. ROI is typically expressed as a percentage. Simply put, it’s how much money you made divided by how much money you spent.
There are many ways to calculate ROI, but if you’re using a mortgage to buy your rental home, the cash-on-cash return approach might make the most sense.
Calculating your ROI involves the following steps:
- Estimate your annual rental income. This requires a bit of research. You can start by researching rent prices for similar properties in the area to understand what you could expect to rent your property for.
- Estimate your annual expenses. When calculating this, include taxes, insurance, maintenance, repairs and any homeowners association fees. Add your mortgage payments, including interest.
- Determine your net operating income (NOI). Calculate your NOI by subtracting your annual rental income from your annual expenses.
- Determine your total cash investment. You can find this by adding together your down payment, closing costs and any upfront renovation or repair costs.
- Divide your NOI by your total cash investment. The result here will determine your ROI.
ROI Calculation Example
- Let’s say you purchase a three-bedroom home for $200,000. You think you can rent the property out for $2,100 a month – which is $25,200 a year.
- Your monthly mortgage payment on the property (including taxes and insurance) is $1,400 a month. You set aside 1% of the property value ($2,000) for annual repairs and maintenance. You pay about $1,500 a year for landlord insurance. All those expenses come to $20,300 a year.
- Your annual rental income minus your annual expenses comes to $4,900 a year. This makes up your NOI.
- Your down payment ($50,000) plus closing costs ($6,000) comes to $56,000. You didn’t invest any money in repairs upfront, so $56,000 represents your total cash investment.
- Your NOI ($4,900) divided by your total cash investment ($56,000) is .09, which means your ROI is 9%.
Is 9% a good ROI? That depends upon your area and your personal circumstances. A “good” ROI might look different in California than it does in Michigan. To assess whether it’s a good ROI for you, try to find out how your property compares to other rentals in the area, and how your real estate investment compares to other investments you’ve made.
How To Buy A Rental Property
Ready to make the leap and become a real estate investor? Here are some tips to help you find and buy your new house to rent out.
1. Decide If You’re Buying With Cash Or Getting A Mortgage
You may be tempted to buy with cash and forgo monthly mortgage payments, but doing so may tie up all of your money into the house. Additionally, you could be missing out on mortgage interest deductions if you purchase in cash. Look at how much money you have saved up and decide if you can afford to buy without taking out a loan. If not, explore your financing options and choose the type of loan that best fits your needs and your budget.
2. Save For Your Down Payment
The down payment required for an investment property is typically higher than the down payment required for a primary home. If you’re buying a rental property, you need a down payment of 15% to 25%, depending on the loan type. It’s a good idea to start saving up as soon as you think you’re interested in investing in real estate. If you’re still short on cash, you may be able to take out a loan to cover the rest of your down payment. Consult a financial professional to discuss the best options for your unique situation.
3. Get Preapproved
As always, it’s important to start with a preapproval since it shows the interest rates and terms you qualify for. Preapproval also shows that you’re a serious and reliable buyer – all good signs of a responsible new landlord.
4. Scout Your Location
Look for a rental property in a neighborhood that’s safe and sought-after. Research local amenities, school districts, access to public transportation and crime statistics before you choose a property. The more appealing your neighborhood and the more popular the area, the more likely it is that you can rent out the home.
Our sister company, Rocket Homes℠ can connect you with a local real estate agent who can help you find the right rental property.
5. Check Rental Market And Rental Prices
Look at a neighborhood’s rental statistics. What’s the average price of rent? How many bedrooms and bathrooms are common for the area? Do most residents choose to buy a home or rent their space? How many vacancies are currently on the market?
Vacancies and rental prices will directly affect your bottom line as a landlord. You need to price your unit to compete with other vacant rental units, but you also need to charge enough rent to make money.
Look for properties in areas with higher average rent prices and lower vacancy rates to maximize your return.
6. Consider Fixer-Uppers Vs. Ready-To-Rent Units
You also need to consider the condition of the rental property before you invest. You have a legal responsibility as a landlord to provide a safe home for your tenants. If you buy a home with a broken heating system or a damaged roof, you’ll need to fix these issues before you can rent it out.
It’s usually a good idea for first-time landlords to choose a “turnkey” property – that is, one that’s in ready-to-rent condition. However, if you have experience in home repair, you may be able to save money with a fixer-upper.
7. Look Into Local Property Taxes
Homes in areas with highly rated school districts and plentiful public amenities often have higher property tax rates. If you’re buying an investment property in a desirable neighborhood, you’ll need to be prepared to pay higher taxes and price your rent accordingly.
The Bottom Line
Being a landlord is a lot of work, but it can also be rewarding. Knowing what you’re getting into is essential to making a successful investment, and if you think you have what it takes to be a landlord, buying rental property could be a good way to diversify your income.
Found a rental property you feel good about? Start your mortgage application so you can get on your way to making rental income.
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