How to Buy Rental Property: Step by Step

Buying rental property can be exciting, confusing, and intimidating, especially if you’ve never done it before and aren’t quite sure what to expect. When you’re getting started in investing in real estate, the scope of possible investments can feel daunting.

Even though figuring out how to buy a property as an investment can be overwhelming, you can do it. The educational materials are out there to help you become the investor you’ve always wanted to be.

Is Purchasing Rental Property Worth It?

Honestly, there are so many reasons why people get involved with rental properties. Even though they are a lot of work, they can pay off in the end. Here are a few reasons why they’re such good investment options:

Cash flow

First, when you buy the right property, you earn a profit every single month in the form of rental income, known as cash flow. Each property becomes like a small oil well: They pump money 24/7. The more units you have, the more financial freedom you get.

Loan paydown

Second, you use a loan when you add to your real estate portfolio, which means you don’t need all the money upfront. You can even add properties for as little as $0 down.

And here’s the cool thing. Over time, that loan is paid off by your tenants. You might start off owing a large amount, like $200,000, but in 15, 20, or 30 years, that’s paid off by someone else.

Appreciation

Third, rental properties tend to appreciate over time, which means while the tenants are paying off the mortgage, the property value is increasing.

Tax benefits

Fourth, many tax benefits go with owning rentals. You may pay very little in taxes – and sometimes no taxes – on the money you make from rentals.

How To Buy Rental Property

Learning how to buy real estate isn’t a linear process. You don’t go directly from point A to point B but instead, you’ll take several detours in your education – from being a complete novice to buying your first property. Although that journey is different for everyone, there is a certain order of steps that can make your voyage into the world of property ownership smooth. 

Step 1: Research

For a lot of people, research is the hardest part, but it’s a solid and necessary first step in figuring out how to buy a property as an investment. Keep reading about real estate market trends and talking to experienced investors and others who are seasoned in the industry. Do everything in your power to learn as much as you can so that you feel confident and prepared to make your first investment in rental property.

Step 2: Determine your location and market

It helps to find your first rental property deal locally or within an hour or two drive of your location. Dig into websites like Realtor.com and Zillow and start looking at different properties in your area to see what the prices are. Get a feel for the locations where prices are higher or lower. If possible, connect with other rental property owners in your area to see where they are buying.

You don’t have to invest in your own backyard when starting, but it makes the journey a bit easier. However, say you want to buy rentals but you live in downtown San Francisco. You can consider a market farther away. Invest where the numbers make sense with the plan you have.

After you’ve defined your market, do your homework to understand as much as possible about that market. Where do people like to live? Where are property prices higher or lower? What are the rents? What about crime? Talking with local real estate agents, lenders, property managers, and other local investors can be tremendously helpful.

When you’re studying what kind of neighborhood you want to invest in, divide them into three classes to make them easier to identify:

• Class A: These neighborhoods include mostly homeowners who typically take a lot of pride in their homes and upkeep them beautifully. That won’t translate into it being a good option for a rental property.
• Class B: This is the middle ground among the three classes. These neighborhoods tend to have a wide variety of people and a mix of both renters and homeowners. This is the best class to invest in, and a 35% to 65% ratio of renters to homeowners is the sweet spot.
• Class C: These neighborhoods are mostly rental properties and don’t have the upkeep of those in Class A. These may not be the best neighborhoods to invest in because they tend to have high turnovers, and you’ll learn that constant vacancies cost you a lot of money.

Step 3: Figure out the money

Getting the money for buying rental property can be a big hurdle for many investors, especially those just entering the game. It can be more complicated to purchase a rental property than it is to get a mortgage for a primary residence. To get the money you need to make your deal happen, you can consider these options:

Get pre-approved for financing

For your first deal, use a bank or local lender to get your financing. They typically require 20% down for a rental property. If you buy a property with multiple units, like a duplex, triplex, or fourplex, and you live in one of the units for a year, you can get a down payment as low as 3%. If you’re qualified to get a VA or USDA loan, it could be as low as 0% down. 

Talk with local lenders to find out what programs they have and what interest rates are for those in your situation. 

If you don’t have enough money to put down or your credit score is too low, you can try networking with other real estate investors in your area. You might be able to partner with someone on your first deal – you bring the deal and they bring the down payment. Obviously, that’s a bit trickier to work out than putting down your own money.

When it comes to owning an investment property, your budget involves more than how large a mortgage you can afford. In addition to considering monthly mortgage payments, you also need to keep in mind the ongoing costs of owning and renting out the property – utilities, maintenance and upkeep, taxes, and more. You then need to weigh those costs against how much you realistically expect to collect in rent from your target tenant.

Search for comparable rental properties in the areas you’re considering, taking into account the size of the properties and the neighborhoods you’re looking at. This will give you a better feel for average rental prices. You can use some of the BiggerPockets calculators to calculate the cap rate, cash-on-cash return, and other financial factors.

Find another investor

Many first-time investors fund properties with private money – that means finding another investor willing to front the money and earn a decent return on their investment.

This may seem like a hard step, but it can be easier than you think. If you’re telling people about your goals in real estate, it makes sense that they’ll ask you about it. Remember that real estate is a numbers game, and you never know when you will be talking about investing in front of the right person.

This is why it is so important to be educated, committed, and have a strategy when you’re buying rental property. You need to know what you’re talking about and have a plan that people can see will work.

Investors have their own language. It includes terms like “ROI,” “cash-on-cash,” “principal,” and “debt service.” You’ll have less trouble finding an investor after you learn the language and start speaking it.

Some people believe that good deals find money, which is why it’s suggested that you get a deal under contract before finding an investor, not vice versa.

At some point, an investor will want to know how much passive income they can expect to make. Some investors will talk in terms of capitalization rates, although some will want to know what their cash-on-cash return is first.

A cap rate is calculated by dividing the net operating income (NOI) by the all-in price. For example, if the net operating income is $6,100 and the all-in price is $110,000, your cap rate would be about 5.5%.

Be conservative in your numbers. Investors will want to know how much you are allotting for vacancy, maintenance, and other expenses. Don’t oversell a deal. It’s far better to under-promise and over-deliver; it’ll make your life easier and help you build long-term relationships with investors.

Step 4: Analyze deals

It may be complicated at first, but you need to start analyzing potential rental properties – and a lot of them – so you get comfortable with deal analysis. Analyze a few deals every day until you find something you think is right for you.

It’s recommended that you buy 10% to 20% below market value. This will allow you to increase your net worth and thus your financial security. If an emergency were to force you to sell your property, you’d have leeway to decrease your asking price and get through the selling process faster.

Keep in mind there are other aspects to pay attention to when you’re looking for a property. For example, your return on investment, or ROI, should be at least 15%. To determine this figure, use the following formula:

ROI = rent – debt and expenses

Additionally, it’s good to know that rent should be at least 1% of the purchase price. That means if you bought a property for $200,000, the rent should be at least $2,000.

Step 5: find the right rental property

At this point, you know you have to start looking at properties and determining what could work for you based on the numbers.

Most people, especially when first starting, work with a real estate agent. Look for an agent who understands the investment side of real estate. Ask to receive automatic emails for the kind of properties you want in the areas you’re considering.

You can also perform research on websites like Realtor.com and Zillow to find out what’s for sale.

Step 6: Make an offer

In a competitive market, you have to be both fast and smart in the offers you make. You’ll get rejected, and that’s okay. Real estate investment is a numbers game.

You might be accepted on one out of every 10 or 20 offers you’ll make. The goal is to make sure you’re always making offers on enough rental properties.

When you do get a property under contract, you’ll pay what’s called earnest money, which is usually around 1% of the purchase price.

Let’s say you are buying a $100,000 property; the earnest money would be $1,000. This is basically your pledge that you won’t walk away from this deal and waste everyone else’s time and effort.

That money is typically refundable only if you either buy the property as promised or back out for a legitimate reason, such as an inspection found there was a serious water problem in the basement.

Step 7: Do your due diligence 

Due diligence is all the work you do between signing the contract and closing the deal.

After your offer is accepted, you’ll need an appraisal and home inspection. The appraisal will provide your lender with an estimate of the home’s current market value. This will cost you approximately $300 to $600.

When you receive your copy of the appraisal, have your real estate agent look it over to make sure the information reported matches up with the comparable properties in your area. If the appraisal returns higher than your offer, you’ve got instant equity in the property. If it’s lower, you can withdraw your offer (if it was contingent on appraisal), challenge it, or attempt to renegotiate the contract – all of which are steps your real estate agent can walk you through.

You’ll also need to schedule a home inspection of the property. Your agent should have a good recommendation for a home inspector you can use.

You should always make your offer contingent on a home inspection because it could reveal some potentially serious problems that may change your desire to buy the property at all or cause you to amend your offer. If the home needs significant repairs and updates, you can go back to the seller to renegotiate a price reduction or ask the seller to fix certain issues before the home is sold.

The inspector will conduct a thorough visual examination of everything, from the home’s exterior and interior to its plumbing, electrical, and HVAC systems. The inspector will alert your agent to anything that needs immediate attention, such as mold in the basement or out-of-code wiring, or may need attention in the future, like an aging roof or an inefficient furnace.

Additionally, your agent’s attorney can help you pick a title company, which you’ll need for the closing. The title company will review the property’s title to make sure there are no claims that could affect the legality of your ownership.

If you’re buying a property that already has tenants, verify the rental amounts as well as the income and expenses.

If you don’t want to manage the property yourself, hire a property manager during this due diligence time. And, of course, get insurance coverage for the property.

At the end of all that, you’ll sign all the documents, wire the down payment, and close on your first property. This is all pretty exciting! But…

Step 8: Don’t forget about taxes

Like state-specific tax credits available to homeowners, landlords also enjoy tax benefits. Interest, repair costs, and other business overhead turn into tax write-offs, while upgrades, renovations, and the overall home itself turn into depreciation.

While you won’t need to worry about claiming these deductions until tax time, it’s good to be aware of them when you’re considering your overall budget and how affordable a home may be for you.

If you’re planning a major renovation, consider what qualifies as a deduction and what must be depreciated over time. This will make a large impact on your cash flow. Talk to a tax adviser if you have specific questions.

How To Manage Your Property

The best deals can be destroyed if rental property owners don’t manage the property correctly and understand landlord-tenant laws.

If you’re planning to use a professional property manager, you’ll pay around 10% of the monthly rent for their ongoing fee. If you choose to manage the property yourself, you can save money, but you’ll need knowledge on how to do it. Here are just a few things to know.

• Advertising: No one is going to know how great your property is if you don’t put the news out there.
• Background checks: One way to ensure you have tenants who will cause as little stress as possible is to do background checks before renting to anyone. Make sure you do this before they sign a lease. Doing this beforehand will not only make your life easier but also be better for your other tenants.
• Security deposits: Security deposits help you financially if issues with rent payments occur at the tenant’s end.
• Maintenance: Things will break or malfunction with normal wear and tear. Make sure you have money set aside for these issues.
• Reserves: Maintain six months of cash reserves to account for events such as vacancies, repairs, and more.

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