Purchasing Rental Property: What to Know
The number of Americans who own rather than rent their homes is growing. The demand for rental housing is huge. But, becoming a landlord is a big responsibility. However, purchasing rental property can lead to significant gains over time. Learn the pros and cons of purchasing rental property and decide whether this is the right investment path for you.
Purchasing Rental Property: Residential or Commercial?
Decide whether you want to purchase residential or commercial rental properties. While the latter does produce higher returns than the former, commercial properties also require a far larger capital investment than their residential counterparts. The financing requirements also differ considerably.
Residential real estate includes single-family homes and multi-family properties with up to five units. Above that number, the property is using considered commercial. Commercial property includes:
- Shopping centers
If you’re getting started in purchasing rental property, it’s probably wise to learn the ropes with a residential investment. Not only is the initial cost lower, but the rental process tends to be more straightforward. The demand for residential housing should remain steady. In contrast, depending upon the type of commercial property, an economic downturn may have a bigger impact on tenants.
How to Find Properties to Purchase
There is no shortage of websites listing potential rental properties for sale. Sites such as Trulia list properties nationwide, including foreclosures. However, that is not the only route for finding such prospects, especially if you want to stay local. Real estate agents should know of available properties or potential sellers.
Location, location, location is always the real estate mantra. Top locations bring top prices, so seek out up-and-coming areas. Good public transportation and low crimes rates attract tenants and protect your investment. Easy access to shopping, employment opportunities and decent schools should be on your radar as well.
Buying a House With Tenants
Keep in mind that purchasing rental property that already has tenants does not change the lease terms. You cannot change the terms of the lease or otherwise violate the agreement just because you bought the dwelling. Tenants with a fixed lease can stay there until the lease expires. On the other hand, if the tenant has a month-to-month lease, the situation is easier. Depending on state and local laws, you can generally raise the rent or notify the tenant to vacate the premises within one to two months.
Buying a house with quality tenants can prove a good deal. The cash flow is immediate and steady. Buying a house with problem tenants can become a nightmare. In a worst-case scenario, bad tenants are the reason the current owner wants to sell.
You need an experienced real estate lawyer to handle the purchasing of any rental property. And this is especially true when buying a house that is already tenanted.
Financing Rental Property
Perhaps you are able to purchase your rental property in cash. If that’s not the case, expect to make a down payment of between 15-20%. Mortgage insurance does not apply to rental properties. As with any mortgage, the down payment will depend on your credit score, income and debt-to-income ratio. Overall, interest rates on rental properties are higher than for primary home loans.
As a rule, 3.5% FHA loans apply only to primary homes. However, if you want to purchase a multi-family unit and live in one of them as your primary residence, you may qualify for FHA financing.
DIY or Hire a Management Company?
If you’re handy and live fairly close to a rental property, you can save money by DIY. Of course, that isn’t practical if your properties are located out of state or if you don’t have the time necessary to attend to your rentals. In such instances, you must hire a property manager to oversee your rentals.
Although the costs of hiring a property manager will eat into your bottom line, the fees are generally worth it. A good property management company can save you money in the long run. And in the short term it can save a lot of headaches. A property manager’s duties include:
- Tenant screening
- Rental marketing
- Serving as the contact point for tenants
- Handling repairs and maintenance
- Familiarity with local landlord-tenant laws.
Since property managers are paid a percentage of the monthly rent, it is in their interest to ensure tenants pay on time.
Purchasing Rental Property Pros
Over the long term, rental properties are generally a solid investment. While generating passive income via rents, the property itself continues appreciating. In investment terms, rental property income is less volatile than other asset classes. This includes stocks and bonds.
There are numerous tax advantages in purchasing rental property. Along with deducting mortgage interest and property taxes, you can also deduct insurance, repairs and your general operating expenses. If you must travel to manage your properties, those expenses are also deductible.
Purchasing Rental Property Cons
There are risks associated with purchasing rental property. Your investment isn’t liquid, so if you need to sell, it can take time. Have an inspector go over the property with a fine-tooth comb so you don’t receive unpleasant surprises about the dwelling’s condition.
Of course, renting property always comes with the risks of bad tenants. Such tenants fall into the categories of those who don’t pay their rent on time. This also includes destroying the property, engaging in undesirable or illegal activities or all of the above. That’s why performing your due diligence and screening tenants carefully are crucial. There are plenty of tenant screening services available. This relatively small investment can save you a world of trouble by rooting out questionable candidates.
What to Look For in a Tenant
What makes a good tenant? There’s no one-size-fits-all answer. However, here are some of the questions to which you need a satisfactory answer whether you DIY or hire a screening service:
- Why are you moving?
- How long have you lived in your current residence?
- How many people will live in the dwelling?
- Are you steadily employed?
- What is your credit score?
- How much of your income do you plan to spend on rent?
- Have you ever been evicted?
- Have you ever broken a lease?
- Can I contact your former landlord and employer?
Ideally, a person or couple spends no more than one-third of their monthly net income on rent. Never rely on the applicant’s word about their employment, credit score, etc. Verify all information in the application. Contact the current or former landlord and find out if the applicant paid their rent promptly and if they were reliable. One additional question is, “Would you rent to this person again?” The answer tells you all you need to know.
Purchasing Rental Property Considerations
Purchasing rental property involves a considerable commitment. Before making such an investment, make sure you have the time and finances to make the investment successful. As noted, find a good real estate attorney to advise you when making your first rental real estate purchase.
About Jane Meggitt
Jane Meggitt specializes in writing about personal finance. Besides investing and planning for retirement, she writes about insurance, real estate, credit cards, estate planning and more. Her work has appeared in dozens of publications, including Financial Advisor, Zack’s, SF Gate and Investor Junkie. A graduate of New York University, Jane lives on a small farm in New Jersey horse country.