How to Buy Your First Rental Property
How to Buy Your First Rental Property
Jeff: What are the steps on buying your first rental property?
Sammy: And what are the pitfalls that you should be looking out for?
Jeff: These are the questions that we are going to tackle in today's video. But first, Hi, I am Jeff Chubb and I am a retired investment banker turned real estate agent that has sold more than a 1,000 houses.
Sammy: And I am Sammy Iliopoulos with Guaranteed Rate and am one of the top loan officers in the country. Alright, Jeff. So, what is the first step when it comes to buying a rental property?
Jeff: Step One is defining your investment goals. You need to know what success looks like, so that way when we find it… Then you can act!
Sammy: So what are some of the things that a potential investor should be thinking about when defining their investment goals.
Jeff: Great question. Defining these goals could be clarity on what type of investment is this going to be. Is this one that you are looking to be more of a passive investment or are you looking to roll up your sleeves and get dirty? Another major part of defining your goals is determining what would be an acceptable return on this investment.
Sammy: That makes sense. So what does an acceptable return look like?
Jeff: Well that is different for everyone and there really isn’t a wrong answer… Except for maybe a negative cash flowing property… Which we will talk about shortly. Sammy, what is step two?
Sammy: Step Two would be to save for the down payment. Buying an investment property is a little more challenging than buying a first home.
Jeff: How so?
Sammy: Generally speaking, if you want favorable financing with the lowest interest rate then you will need to put 25% down. And even then, it’s important to remember that this interest rate will be higher than the rate for a primary home that you are buying to live in.
Jeff: How big of a premium are we talking about here?
Sammy: It depends on the day and the mood of the market, but upwards to a half point! Remember that it isn’t impossible to buy an investment property with a smaller down payment, it’s just that the terms won’t be as favorable.
Jeff: Which leads us to Step three which is taking steps to qualify for a loan. Sammy, why don’t you walk us through this one?
Sammy: The steps to qualify for a loan when buying an investment property are similar to when buying your first house. You are going to get the best interest rate if your credit score is above 740. You will need 2 years of tax returns, the last 2 to 3 months of bank statements, W2s as well as paystubs.
Jeff: Sorry, but I just want to chime in here and say that you also want to make sure that you are looking at what you are sending over! Banks will look at the last 2 to 3 months of bank statements and will go over this info with a fine tooth comb. Don’t have any big deposits here that you can’t really explain.
Sammy: I think you are talking about seasoning. Yes, you are right. Let’s say for an example that your parents are going to give you money towards the down payment. Giving the money a statement before your loan officer needs it, then that means the money would be seasoned and there would be no additional scrutiny from the bank's end.
Jeff: Real quick, my shameless plug. If you are thinking about buying or selling a house, then reach out to Sammy and I. We would love to help you.
Jeff: Now, Sammy. Why don’t you talk to us about getting Pre-Approved for a loan which would be Step four.
Sammy: The pre-approval process is relatively easy if you have taken the time to prepare. And we make it even easier with an online portal where you upload all of those documents to.
Sammy: I always recommend people to go through the pre-approval process before looking at houses. Sometimes some surprises may come up here and the budget will be less than what someone expected.
Jeff: I think that is a really great point. Always get your pre-approval first as it will help keep you grounded with the prospective investment properties in your price range.
Jeff: So what else should a potential investor consider during the pre-approval phase?
Sammy: They will most likely want to keep the investment as a single to four family property. This is because 5+ units will require commercial financing which is more expensive and harder to obtain.
Jeff: Anything else?
Sammy: Yes. Stay current! Don’t miss any payments. Stay diligent on your credit. One late payment can best case scenario make your borrowing cost higher and worst case scenario jeopardize your ability to buy today and push that timeframe out 6 plus months.
Sammy: Step Five is to identify the type of property. Jeff, what can you tell us about this?
Jeff: I think some great advice when you are buying your first property is to buy something within an hour radius of your current house. The reason being is that you will likely have some good insight on these areas. Like what you consider as a good area, bad area. Or high crime areas. Or maybe an area with good or bad schools.
Sammy: I couldn’t agree more. As a first investment, it’s always better to be safe… Otherwise you could end up really sorry.
Jeff: I would also recommend that someone think in the terms of “average”. Average means something different to everyone and everywhere else. As a great example, the average in our market is that $500,000 ballpark for a single family home. That’s a luxury property in a lot of my markets around the country.
Sammy: That makes sense. There is risk to a potential investor on both sides of the spectrum. Going to the high end as well as going for the lowest price point.
Jeff: Exactly. There is safety in averages.
Jeff: You will also want to consider which market segment you are looking for. And there are positives and negatives to all of them.
Sammy: Like what?
Jeff: Well as an example, a condo will have a condo fee. And it can eat into a lot of your margin depending on what that condo fee is, Plus, you are at the will of the condo association in regards to it going up or even them leveling a special assessment at you. But with a condo association, there is a lot less management of the property! Single Family properties are great because there is a lot more of a supply when it comes to those properties. But there is also a lot more upkeep. Upkeep comes at a cost. Multi-family properties can be an amazing investment. But get ready for a lot of upkeep plus dealing with multiple tenant issues under the same roof. And multi-family properties come at a premium.
Sammy: And don’t forget the investor limits that can oftentimes be put on condo associations. But I think the most important thing when finding a property is about finding a Positive Cash Flow Property.
Jeff: I couldn’t agree more. And that has become challenging in this environment with high rates and low inventory levels. Sammy, let’s walk through this a little bit.
Sammy: The first thing you will want to do is get an estimate on the loan payment for the property. You will then want to add in taxes, property insurance, Home owners fees, utilities and the vacancy rate.
Jeff: There is a lot there, so let’s break all of this down.
Sammy: Let’s say the rental property that you are interested in is $500,000. This means that at a 25% down, the down payment would be $125,000.
Jeff: And let’s just use a 7.5% interest rate today. Keep in mind that when you watch this video that interest rates could be up or down. We are using the mortgage calculator at MortgageNewsDaily.com which is pretty awesome.
Sammy: So let’s add $1800 for property insurance and $4500 for the taxes and this brings us to a payment of $3,147 per month.
Jeff: We really should add in the Vacancy Reserve cost as well.
Sammy: First, talk about what a vacancy Reserve is.
Jeff: Sure, the Vacancy Reserve is a calculation based on how long the property would be vacant for in a given year and applying that expense to the monthly expenses. So if a property was vacant for one month each year, then the vacancy reserve would be 10% of the collected rent roll.
Sammy: Correct me if I am wrong, but most people use a 5% Vacancy Reserve number, correct?
Jeff: That is correct. 5% of the monthly revenues. So now that we have a hold of our expenses, then we need to get an estimate of what type of rent a property would receive.
Sammy: And Zillow has some great estimates for what property rents would be. You can also search their database for current rentals and get an idea of the comps.
Jeff: So, to keep to our hypothetical world, let’s say the investment property would rent out for $3,700 per month.
Sammy: This means we would want to take the $3,700 and subtract the principal, interest, insurance and tax payment of $3,147.
Jeff: Plus the vacancy reserve of $185 per month. Then add in water and sewer and maybe lawn care as an example. Let’s say that’s $100 per month. So that is a grand total of $3,432 per month in expenses.
Sammy: Which means the net would be $268 or a cash on cash return of 2.6%
Jeff: Well that doesn’t sound great…
Sammy: Yes, on the surface, that isn’t a great return. BUT you are paying down the principal on that loan each month. You should be adding that back in.
Jeff: That is a great point! In year one, the principal paydown is $3,457. Adding that into the equation, then that would mean that your ROI would be 5.5%
Sammy: And that is in year one. Rent rolls should grow with rental rate increases while you will start paying down more and more principal each year.
Jeff: There was a lot with step 6. Let’s talk about buying a home in need of some minor repairs as Step Seven.
Sammy: I think the keyword here is… Minor repairs!
Jeff: Yes, you do not want overly complicated for your first investment. Stay away from development projects and entire house flips. If you see a house and it needs some flooring and paint, then I would say you are on the right track.
Sammy: Exactly. Stay away from Roof or system upgrades if you can. Even Kitchens… A full Kitchen gut can cost you an arm and a leg!
Sammy: Step Eight is finding a Real Estate Agent… Jeff, do you have any thoughts on this one?
Jeff: Ha, ya. I have some thoughts! You want to choose an agent that is experienced. But not just experience in sales, you also want someone who understands the investment world. Do they know what a Cap Rate is? Do they know how to calculate a Cash on Cash return? Can they look at a property and provide suggestions on ways to improve the investment to provide a greater return?
Sammy: I would also probably throw in that you probably want an agent who does some investing themselves. Essentially making sure they are putting their money where their mouth is!
Jeff: Yes, I always get some amusement from agents who rent, but tell other people that buying a house is one of the most important things they can do.
Sammy: Basically you are saying that you want to interview your agent and not just start working with the first person who opens a door.
Jeff: Great way to sum it up. Step Nine is to write offers and be patient!
Sammy: This process may take a little longer than you hoped… Or planned!
Jeff: It’s as simple as the numbers work or they don’t. Don’t stretch. It makes no sense to have an investment property where you lose money every month. Stay honest to your calculations as well as your process.
Sammy: One thing that I have learned over the years with all the investors that I have worked with… It’s that when you are investing, you often need to kick over more rocks. Be selective and find the right investment.
Sammy: But when it does all come together, then that is when it brings us to Step Ten. Step 10 is the offer getting accepted and doing all agreed upon inspections.
Jeff: Many times investors will write an offer that is non contingent on a home inspection. As a new investor… Don’t do that.
Sammy: Unless of course you have had a pre-inspection done.
Jeff: Yes, unless you have done a pre-inspection. It doesn’t take much of a repair to turn an investment upside down.
Sammy: As a first investment, you will start to put together a trusted team. You definitely want a good inspector to be on that team. Not an alarmist of an inspector, but someone who can be frank with you and tell you what you need to hear… Not what you want to hear.
Jeff: And that leads us to Step Eleven in the buying process which is preparing for the closing. Sammy, talk to us about closing costs.
Sammy: Closing costs on the property are going to range in the 1.5 to 2% range of the purchase price.
Jeff: What are some examples of closing costs that we pay at closing?
Sammy: You have some lender fees, title recording fees, title insurance is a big one. Another big one is insuring the property.
Jeff: And some state’s have a transfer tax that the buyer is responsible for a part of. The seller pays the transfer tax here in Massachusetts, but it can cost you a pretty penny in other states.
Jeff: Another thing that you hopefully have already thought of is how you are going to take title on the property. With it being an investment property, then you may want an LLC to hold the property. If that is the case, then you will want to ensure that the LLC is setup before closing.
Sammy: And that leads us to Step twelve which is making any improvements to the property. As we mentioned earlier, if this is your first rental property, then you may want to consider keeping the renovations on the light side. Think paint, flooring and other minor touch ups.
Jeff: And if they are things that you can personally do, then that is even better. It will increase your return!
Sammy: Also remember that time is of the essence. The longer it takes you to do these improvements, then the longer it takes to get a renter in the property and start generating revenue.
Jeff: And generating revenue is our entire goal of this process, right? And that leads us to Step thirteen when buying an investment property. You will need to get the property rented out.
Sammy: When renting out a property, then I HIGHLY recommend hiring a real estate agent. Yes, for their general knowledge in pricing a property, but also from the liability standpoint.
Jeff: Yes, us agents have errors and omissions insurance! Landlords do not!
Jeff: An agent will help with pricing to tenant screening and everything in between. And here is the best part, in most cases the tenant actually pays for the broker fee. In other words, in most cases, it doesn’t cost you anything.
Sammy: Another consideration is hiring a property management company. But keep in mind that this could cost you 5 to 10% of the rent roll.
Jeff: In most cases, I don’t think it makes sense as you start the investment journey to have a property manager. That 5 to 10% is an important part of your margin in order to grow your investment empire.
Sammy: I 100% agree. But I just think it’s important to know about this as an option. And then there is Step Fourteen.
Jeff: Yes, step fourteen is a good one. Save up for the next investment property.
Sammy: Yes, rinse and repeat! Real estate is a long term play in becoming wealthy.
Jeff: You know Sammy, I heard a great quote the other day. It was something along the lines of that being wealthy is when your investments make you more than your expenses.
Sammy: That is a great quote and an even more amazing mindset. Ultimately real estate is the key to building generational wealth.
Jeff: And like with all great journeys, it all starts with the first step. If you are thinking about buying your first investment property, then reach out as it would be a pleasure to talk. Yes, I only work in Massachusetts, but have very qualified associates all around the country that can help you find the perfect investment property.
Sammy: And I can help you in going over your financing options whether you are looking to buy in from Massachusetts to California and everywhere in between.
Jeff: Great point as it wasn’t so long ago that you helped my brother buy his investment property down in Florida!
Jeff: You can also reach me at YouTubeRealEstateAgent.com and can find all of our information in the description below.
Sammy: Until next time.