The Beginner’s Guide to Investing in Rental Properties

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If you’re considering investing in the rental housing market, you may be wondering how to get started. Like many new investors, you probably have an optimistic view of your new investment property: reliable tenants, passive income and possible financial freedom. But how do you get there from where you are now? Like everything else, you start with the basics. Understanding even the rudimentary principles of rental real estate can help you launch a successful investing career.

This includes knowledge of property types, return on investment, mortgages and the legal steps to acquire a home. The research you do beforehand can help you avoid a misstep that could hurt your investment. Here’s how to get started investing in rental real estate:

Related: 5 Tips For New Investors Looking To Make Money With Real Estate

Choosing between a residential and commercial property

Before buying a property, you need to decide whether you are looking for a residential or commercial property. Both types can help you reach your end goal of passive income. However, they have some important differences.

  • Residential real estate: Residential real estate is real estate that you rent out to someone who is looking for accommodation or a main residence. Your tenant(s) can be a family, a student, a young professional or someone else. Homes generally have lower start-up costs. Residential mortgages are also easier to obtain, as banks tend to accept lower credit scores than for commercial loans. There is also a higher demand for housing so you can fill your units more easily.

  • Commercial real estate: Commercial real estate is real estate that you rent out to a company. The company can use the property for retail, office or industrial purposes. Commercial real estate requires commercial mortgages, which are slightly more complex than their residential counterparts. In some states, buildings with more than five units are automatically classified as commercial real estate for tax purposes. Ask a mortgage adviser in your country whether this rule or a similar rule applies.

Assess property value

Now that you have selected a property type, you need some options. Maybe you’ve picked a neighborhood or a few properties you’re considering. How do you know which is your best financial move? Here are two crucial factors to consider when assessing real estate values:

  • Place: Location means everything to potential tenants. Is the property near commercial areas, within walking distance of a downtown area, or otherwise in a convenient location? These factors make the home more attractive and justify higher rents.

  • School Districts: Position within a top school district is more important than you think. In fact, school districts are one of the biggest determinants of tenant and buyer demand, and in turn, return on investment. Good school districts attract young families who are willing to look beyond the drawbacks and pay more for quality education for their children.

Related: Getting Your Feet Wet in the Rental Industry

According to the 1% rule

Qualitative factors are one way to measure the return on your investment, but you also need the numbers to back up your assessment. Will the property generate consistent rental income? Or does the property end up costing you more time and money than it can return to you? Fortunately, there is a rule of thumb for assessing the strength of an investment that you can apply before making it.

The 1% rule believes that if you can reasonably rent out a home at a rate equal to one percent of the initial mortgage, it is likely to be profitable. You need to know if the rate you have charged is reasonable based on the demand and rates of comparable properties in the area.

Let’s say you buy a duplex for $310,000. You make a 25% deposit, equal to $77,500. That leaves you with a $232,500 mortgage. One percent of this remaining mortgage is $2,325, which is cut in half at $1,162.5. If you can rent both units of the duplex for about $1160, the property is probably a good investment.

The 1% rule is a quick trick to evaluate an investment’s potential. However, it should not be taken as a final judgment. The soundness of an investment depends on many factors, including your current cash flow, the condition of the property, property tax rates, location trends, and other factors. The 1% rule puts you in the margins, but do your due diligence.

Financing your real estate

Finally, you have chosen a property. If you are like most investors, you need to borrow money to buy it. This means finding a mortgage lender, negotiating terms and making a down payment. Let’s break down mortgage types, down payments and interest rates:

  • Mortgage types: There are many different types of mortgages. The two most common are fixed and floating rate mortgages. Fixed rate mortgages have a fixed interest rate over the life of the loan, while adjustable rate mortgages have an initial fixed rate that changes as the loan ages.

  • Deposits and Interest Rates: In addition to choosing a mortgage type and term (15 years, 30 years, etc.), you also have to make a substantial down payment. Larger down payments will help you get lower interest rates because your lender is taking on less risk. Conversely, smaller down payments come with higher interest rates. Deposits of about 20% are usually considered sufficient.

Related: How to Get the Most Out of Your Rental Property Investment

Legal checklist

As a buyer, it’s your job to get ahead of a purchase before problems arise. Here’s what you need to do to make sure your investment is well protected before making it official:

  • To verify titled documents: A title deed, transferred in a physical deed, confirms the ownership of a property. Before signing a purchase agreement, review the most recent deed on file and verify that the seller is the current owner. This can be done through a title company or attorney. Then check for any liens on the property. Retention rights are claims on a property placed by a lender while the owner still owes money. Ownership cannot be transferred if there are active liens on it. Finally, the title documents must be signed by the seller and buyer (you) to formally transfer ownership.

  • Buy title insurance: Property insurance protects you if something unpleasant, such as an undetected lien, is discovered after you transfer the title. Some lenders require it to obtain a mortgage. Title insurance is usually around $1,000.

  • Confirm the property tax receipts: Then confirm that the previous owner has paid all necessary property taxes. Ask the seller for receipts directly or obtain them from your local government tax office.

  • Carry out an inspection: Hire a professional home or building inspector to see if there are any issues you should know about before buying the property.

  • Sign the real estate purchase agreement: A real estate purchase agreement is a contract between you and the seller. Like any other contract, it covers the price and any negotiated terms of the purchase. Your broker takes care of the agreement. Communicate with them about any issues or conditions you want to include.

Every successful investor started right where you are now. The research and dedication you put in upfront can also help you achieve financial freedom. You are now ready to buy your first home and get started with real estate investing.

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