Buying rental property is my favorite way of building wealth. Stocks are great, but real estate investing adds a little spice to the wealth-building journey. Rental property investing is not as passive as investing in stocks, but if you hire a property manager, you won’t have to deal with broken toilets or angry tenants. Your manager will take care of that for you.
Rental property investing is my favorite wealth-building tool because of the following three reasons:
Leverage is the use of debt to acquire investments assets. If you have read my other blog posts, you are aware that my husband and I have used a significant amount of debt to grow our real estate portfolio. Debt allows us to play in the real estate game without having all the money at hand.
Mortgage interests rates are normally lower than the returns on the investment which means that the rental property income will pay for the debt used to acquire the investments and more. One can argue that you can buy stocks with debt, but most banks will not lend you on your stock portfolio whereas lenders will give you a loan on rental property.
Many people are scared to get into debt, but I am a huge proponent of good debt. I started investing in real estate without having any money of my own (read more about this here). If had waited until I had the money to start investing, retiring at age 37 would not be an option.
Having a consistent monthly income is key for our retirement plan which is why rental property fits in so perfectly. Our goal is to use the monthly property income to cover our monthly living expenses and allow us to quit our day jobs. Plus there is nothing like receiving rent payments on the 1st week of the month.
Properties with high cash flow are not easy to come by, but they are out there. A lot of real estate rookies get disappointed because they overestimate how much cash flow they will get from a property. Personally, we aim for $200 net cash flow per month per property. I will be writing a blog post about this soon, so stay tuned.
A lot of people actually get started in real estate because they are looking to reduce their taxes. Investment property allows you to write off a lot of property-related expenses and therefore, reduce your rental income. One of the biggest tax real estate write-offs is called Depreciation. Basically, the IRS says that your investment has a limited useful life before it requires a massive improvement. In the case of a residential property, the expected life is 27.5 years. So what does this mean? The IRS lets you expense a piece of the property costs each year and after 27.5 years, your property will be valued at $0 for tax purposes.
To calculate this write-off, you get the property cost (excluding land) divided over 27.5. On a property purchased for $100,000, you may be able to write off over $3,000 a year. For a lot of investors, the depreciation write-off will either wipe out any property income or even generate a loss that can then be used to offset other income such as dividend income.
In my case, I don’t have to worry about owing money to the IRS for any of my rental properties because depreciation has me covered. At the time of this writing, the real estate write-offs will even be sufficient to cover all of my passive income including dividend income from my stock portfolio.
I wanted to point out why I love rental properties because it is important that you figure your WHY before you even start your real estate investing journey. To be completely transparent, getting started in real estate is not a walk in the park and can be frustrating at times. When the time comes, you will need to remind yourself WHY you even started. If you don’t have that foundation, you are likely to fail or quit eventually. I know that sounds harsh, but it’s true. You have no idea how many times I have questioned my decision to continue investing in real estate, but I remind myself each time why I am doing it.
Now, let’s discuss the top 6 things that you would need to start working on before buying your first rental property.
1. Know Your Credit
While you don’t need a perfect credit score, your credit score will determine your ultimate investment strategy. You may need to get your credit situation sorted out before you get started and this can take some time. It is not impossible to get started with bad credit, but it will require creativity. Unfortunately, creative strategies more often than not, come at a higher cost.
What credit score should you be aiming for? According to an article by CNBC.com, below are the scores are required based on the type of mortgage loan you are looking for. These are just standards set by Fannie Mae or Freddie Mac, but lenders may set higher standards. From what I have seen so far, 620 is the minimum accepted by most lenders and the interest rate will not be that great. To have a better shot at getting a painless loan, a 700 credit score will likely be where you to be.
Read the article here.
- Conventional Loan: Min. score 620
- FHA Loan: Min. Score 500 (10% down) or 580 (3.5% down)
- VA Loan: N/A, but lenders may set discretionary minimum.
- USDA Loan: N/A, but lenders may set discretionary minimum.
Again, not having a better score does not mean that you cannot buy an investment property. It just means that you will have to do a little more work to get there. If you really wanted to get an FHA loan, for example, you would probably have to call around until you find the right lender or program.
A lot of times, a lower credit score can be offset with a higher down-payment or upfront interest payment. You may also be able to get a guarantor or add additional collateral to offset the lender risk. Additional collateral might be your car, your business, etc.
This is why checking your credit is at the top of the list. If you are just getting started, you can work on your credit while you do the next step.
While real estate doesn’t have to be complicated, there are a few things you want to know before you get started. We don’t want you to start completely blind. Reading this blog and listening to podcasts for example. All of BiggerPockets books, blogs, podcasts, and forums are great sources for real estate education.
You don’t need to study for a full year or earn a master’s degree in real estate, but at a minimum, you need to know how to analyze deals and understand what it takes to run a property. Not knowing this is why many investors fail.
A lot of investors will look a the property’s rental income and the mortgage payment and that is how they determine whether it is a good deal or not. While this could be a good first measure, there are several other expenses that come with owning a property. Not anticipating these expenses will lead you to lose money from day 1.
Read my blog post about analyzing rental properties here to get a detailed overview.
Exploring can be done at any stage of the game. You might start exploring to help you solidify your WHY and your strategy.
Go to Zillow, Realtor.com, Redfin, or any of the online real estate free listing websites and start exploring. You can start with a Google search for Real Estate for sale near XYZ city. The best place to start looking is your neighborhood or a place that you are already familiar with. What is listed in the neighborhood? What are the rents? What type of properties?
Personally, I start with my city and then start zooming out more and more until I find the area that has my price range. This is how I found Macon, GA which is 1 hour and 1/2 away from my house.
I recommend that you have an idea of what is out there before speaking to a realtor. Realtors are great to help you get to the finish line, but if you don’t know what you want, it is going to be really hard to communicate with a realtor. You also want to have realistic expectations. You can’t ask your realtor for a $10,000 house in Miami. Not happening.
I usually do my own research and then go to our realtor and get further insight from her. “Hey Kathy (my realtor), I found this city called Macon and the prices fit with my budget, what are your thoughts?” My realtor will then help me narrow down my search, get me sales and rental history so that I can get a better understanding of the market. Unless I know what I want, my realtor is not going to guess that I am willing to invest that far out from home.
4. Find a Lender
Depending on your credit situation, finding a lender may come earlier or later down the road. If you are going to be using any type of financing, I would recommend starting earlier than later. Starting the conversations earlier will help you be better prepared for when the time comes. The initial conversations may just be to discuss the pre-qualification requirements and get to know the lender’s business style.
If you are going to use a conventional lender, financing is likely going to be the worst part of the process. If this is your first time buying a house, you are in for a fun ride. The financing process is what I dislike the most about rental property investing.
Be prepared to provide documents and explanations for the most ridiculous things.
This is why finding a lender that is easy to work with and communicates timely is important. You also want to make sure that the lender does a complete preliminary underwriting of your financial profile as part of their pre-qualification. This means that they not only check your credit but verify your income during the pre-qualification period. The last thing you want is a lender that will not accept your income because of the source.
I could write a whole blog post about financing nightmares, but to keep it simple, here are three things that I have learned the hard way during the financing process.
- Keep your bank account activity to the minimum prior to and during the financing process. You have to be able to explain large deposits or withdrawals from your bank account. I have multiple bank accounts and one time I accidentally transfer money into the wrong account and I had to transfer it back. It was a huge ordeal trying to explain to the underwriter. Leave the down-payment money where it has been for the last few months and don’t move it until it’s time to close.
- For investment properties, most lenders will require you to have 6 months’ worth of mortgage payments in cash or liquid assets as reserves. You could use a stock portfolio or retirement account as proof of reserves, but keep that in mind. We usually provide our retirement account statements as proof.
- For investment property purchases, “Gift” funds are not accepted as they normally are for owner-occupied properties so you must prove that you have your own money for the down-payment. We tried that with my dad’s property and they wouldn’t take my money as proof of funds.
Finally, keep in mind that most realtors will not do showings without a pre-approval letter. Plus, you want to be ready to make an offer as soon as you find the perfect property.
5. Find a Realtor
All the books say to get a realtor that is investor savvy, etc. However, I personally don’t think this is as important when you are starting out. In the beginning, getting started is what matters. Rather than spending your energy finding the BEST realtor for real estate investors, use that time to learn how to identify good deals and determine the investment type you want.
It doesn’t mean you don’t look for an investor savvy realtor. You should still keep an eye out for referrals, but if it doesn’t come your way, don’t just get held up on this.
Find a realtor that will give you access to the Multiple Listing Service where you will get access to more details on properties listed for sale.
Our realtor set up a search in her system based on the requirements we provided and we get daily updates with new properties. Whenever something piques our interest, we then reach out to her. She will get further information, schedule the showings or send the offers on our behalf.
Nowadays, she also does the walkthroughs on our behalf while we are at work. All we have to do is tell her what we want, send the money, sign the docs.
This may sound silly, but it’s quite important. Once you have spoken to a realtor and gotten access to the listings, figure out what type of investment you want.
You want to narrow down your search as much as possible.
For example, “I want a single-family home rental in the $100,000-200,000 price range with a monthly rent of $1,000-2,000 per month in these zip codes.”
You at least want to have down:
- Your max purchase price
- Your minimum monthly net cash flow requirement
- The cities you wanting to invest in. I would suggest keeping it to no more than 5 zip codes.
Suggest you brainstorm and narrow down
- The type of property: Single-family, Multi-Family, or Commercial
- The state of the property: rented, rent-ready, cosmetic rehab, full rehab, or new construction
- The class of the property:
- Class A: Newly built. More in the high-end luxury spectrum. Higher rental rates and higher quality tenants than the classes below. Located in high-demand areas with a great school district and good transportation system. Usually will have a higher cost of acquisition, but good long-term returns due to appreciation.
- Class B: A little older than Class A properties, but in good neighborhoods with good schools and in decent conditions. They are not as high-end or as new as properties in class A, but these are probably the best type properties because you can potentially turn a class B property into a class A property with the right strategy. The cost of entry is lower than class A and while rents are not as high, the returns can be more profitable than Class A properties due to the lower investment requirement.
- Class C: Older properties (30+ years) with significant deferred maintenance. Often located in neighborhoods with a high crime rate and therefore, have lower rents. Tenants will normally be lower-wage working class. These properties have good potential and are normally more affordable than Class A or B properties. However, with older homes in need of repairs, they pose some risk given the unexpected cost of repairs. Personally, this is the property class Ryan and I prefer.
- Class D: Older properties similar to class C, but in a more neglected state and in less desirable neighborhoods with high criminal and drug activity. Normally, the cost of these properties is lower and may bring high returns, but they also bring higher risk. The risk of evictions and having the property neglected by tenants is a big concern, but many investors successfully invest in these property classes.
It is easy to get overwhelmed with all the different investment options, but try picking the strategy that calls to you the most and go with it.
In an upcoming post, I will walk you through our investment strategy so that you can get an idea of what this looks like in practice.
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