How to Buy Your First Rental Property
March 1, 2023
March 1, 2023
Yep!Real estate can generate profits, including your own house.
Perhaps by renting out storage space in your garage or basement, you are bringing in some extra money. You could even rent out an occasional room on Airbnb, or rent a room through the sharing economy to a roommate, or some other sort of house hacking.
By renting out an entire house, ready to up your game?
The purchasing of long-term rental properties, along with a few threats, comes with a slew of benefits. The good news is that by good ol ‘fashioned planning, you can minimize each risk.
You gain financial freedom when you generate enough rental income to cover your living expenses, and your day job becomes optional.
Here’s what you need to know about the construction of passive rental property revenue and how to ensure that you always come out ahead.
Why should you purchase a property for rent? As compared to bonds or securities or a mutual fund, what makes it a good investment?
Consider these benefits for long-term real estate investments as you explore where to invest your money.
Rental assets come with an abundance of tax advantages.
The IRS allows any possible expense to be deducted, plus other paper expenditures such as depreciation. You can subtract most closing costs, property management costs, mortgage interest, property taxes , insurance, legal fees, maintenance costs, and more on most closing costs (and some can be depreciated).
Best of all, even though you take the regular deduction, you will take these deductions. No needed itemizing!
You cross your fingers when you buy stock, and hope for the best. Also, bonds that state their returns upfront, depending on the interest rate environment of the day, fluctuate in resale value.
By comparison, rental properties offer returns that you can measure in advance. You know the rent on the market, you know your purchase price, and you can accurately forecast expenses.
Where too many new investors in rental property screw up is in ignoring or underestimating the expenditures that are irregular, yet unavoidable. Alternatively, investors need to take the long-term average of costs such as vacancy rate, maintenance, and major repairs. They don’t hit on a monthly basis but hit semi-regularly.
Fortunately, you can reliably forecast them. For example, by interacting with local property managers and landlords who work there, you can easily discover the vacancy rate for a given neighborhood.
Rental properties eternally produce income.
They never age, they never quit paying dividends, they never declare bankruptcy. They can burn down, of course, but insurance protects you from the risk.
You’re beginning to collect income now, and you’re going to collect even more income in 30 years from now. After the initial property acquisition, all without having to raise a finger, if you want to employ a property manager. If you don’t, more and more options are at your disposal to automate your property management.
You have to deduct inflation for most investments to obtain the actual return. For instance, if a five-year bond pays 4 percent interest, but inflation runs at 2.5 percent over the five years you keep the bond, then the actual return on investment is only 1.5%.
For rental properties, this is not the case.
Not only are rents rising alongside inflation, they’re one of inflation’s main triggers. Rents almost always increase at or faster inflation rates, so you’re secured implicitly against the slow ebb of inflation that drains your returns.
The impact compounds when you use the money of other people to purchase your rental properties, too.
You’re faced with a particular issue when your retirement portfolio consists of stocks and bonds: they often don’t generate enough ongoing income to survive on.
This means that over the course of their retirement, seniors have to gradually sell their nest eggs, and hope they don’t run out of money in their lifetime. They worry about issues such as secure withdrawal rates and return risk series. Living with it is a horrible fear and many retirees are continually testing their remaining fund balance for themselves.
Rental properties, on the other hand, keep producing revenue indefinitely with an average yield of 10-15%, which is almost twice what stocks and bonds would give you. Not to mention, in order to produce that kind of money, you do not have to sell your rental property.
Just the opposite: over time, they just become more important.
Rental properties increase in value over time as a general rule, since demand for housing increases over time. In the meantime, housing supplies, given the steadily growing labor and material costs and the limited supply of suitable property, are becoming increasingly costly to manufacture.
Values are going up steadily, and your mortgage balance is going down steadily. So, even though you raise money on rentals every month, you build equity, too. For instance, in a good market, property prices across the United States rise about 3-5 percent each year.
Real estate lets you leverage the resources of other people to create your own asset portfolio. A portfolio that pays you cash to boot each month.
Thus, with a rental property loan, you can fund much of the purchase price, make a monthly profit, and then your tenants pay off the loan for you. Speak of win-win!
If you want, you can also use your rental cash flow to pay off your mortgage sooner and get rid of the monthly payment.
But before you do, note that each month your mortgage payment remains the same, even as your rent increases. That means that at a faster pace than your rentals alone, your profit margin increases.
Imagine $1,000 in-home rentals, $500 a month in rental property loans, and a total of $400 in non-mortgage expenses. So, your margin for monthly cash flow is $100.
Rents in your market are growing by a healthy 4 percent over the next year. The rent goes up to $1,040, but it remains the same for most of your expenses.
So, your monthly cash flow grew from $100 to $140: a profit gain of 40 percent, even though the rent increased by just 4 percent!
That’s the beauty of leverage.
Before committing, be sure to compare rental property loans with interest rates , fees, down payments, and conditions, as most loans last 15-30 years and refinancing is costly.
Also Read: Things to Consider Before Moving into a Rental Property
All upside and no risk is no investment. And although with a rental property calculator you can predict returns, not everybody calculates it correct.
Here are the three main threats facing rental property owners, beyond miscalculations.
Vacancies are a fact of investing in rent. No property will ever have a 100 percent occupancy rate.
So many tenants are worried: what if I can’t rent my property and for a long time it stays vacant?
If before buying, you ran the numbers correctly in a rental property calculator, you can budget every month for the vacancy rate. For instance, if the neighborhood of your property has a 5 percent vacancy rate, 5 percent of any rent payment for potential vacancies should be set aside.
Bear in mind that there are no high vacancy rates in healthy neighborhoods. You should have no problem re-renting your property if you choose a neighborhood with relatively high demand.
What happens if the rent stops being paid by the tenants?
Often it occurs. But thankfully, not too much, and you have many ways to avoid losses due to rent defaults.
Second, by screening your tenants extensively, you can avoid losses. That begins with reports like credit, criminal, and eviction reports, but there’s no end to screening. You can also check their history of wages, employment, and rent payments.
But you can still buy insurance against your defaulting tenants nowadays. It usually costs $300-400 a year, and the insurer covers it while you file eviction and find new tenants if your tenant stops paying the rent.
Because of rent defaults, landlords will essentially eliminate the possibility of damages between aggressive tenant screening and rent default insurance.
Also Read: How to Protect Your Vacation Rental Property
Another danger comes from the damage to your property by tenants. And let’s face it: you’re offering them ownership of hundreds of thousands of dollars worth of properties.
With tenant screening and insurance, you can also minimize this risk. Stop by their current home and see how they live before accepting an applicant that otherwise looks fine. Are they treating it with respect? Are they clean?
They’re treating that house, though, that’s how they’re treating yours. Decide correspondingly.
Some cover against harm caused by tenants is also offered by insurance policies. But make sure to carefully read the fine print and ask your agent what is covered and what is not.
But a simple security deposit is the conventional defense against tenant harm. Take the cost out of their deposit when they move out if they harm your house.
Finally, carry out semi-annual checks to find problems early, and either evict or non-renew tenants who do not treat your rental property with the respect it deserves.
Like any investment, rental properties do come with risks. But with simple planning and foresight, you can handle and minimize those risks.
You will gain continuing income in exchange, which increases much faster than inflation, and appreciates all the time. Profits from assets that you can largely acquire with the money of other citizens, even though you reap tax benefits and generate equity.
You can cover your monthly living expenses with ample passive rental income, and achieve financial independence and early retirement (FIRE).
If there’s a drawback, it’s that rental properties take some effort and experience to purchase, beyond the risks described above. It’s a barrier to entry, which prohibits investing by the average citizen.
But it’s that very barrier to entry that keeps the returns higher for those willing to take on that initial investment of knowledge and work. In other words, that barrier weeds out the indifferent, leaving only those who truly want it.
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