Investing in rental property can be a great way to build wealth outside of the stock market. Some benefits include the appreciation of the rental property itself and the potential for regular rental income from tenants.
That being said, with any type of investment, there are risks to consider. While rental property investment can come with steady income, you’ll need to respond to market conditions, such as fluctuating rent prices, whether your location continues to attract tenants, and dealing with tenants who don’t pay rent.
Should you invest in a rental property?
Yes, there is the potential to earn a decent amount of wealth in rental property, but it’s not the right type of investment for everyone. Though it’s typically considered a type of passive income, there is a fair amount of work you’ll need to put in, especially if you want the potential for a higher reward.
For one, you’re ultimately responsible for financing rental properties, whether it’s through a traditional bank loan or property investors. You will also most likely need to put up a large amount of upfront capital, whether that’s for a down payment or renovations and repairs.
Plus, despite your best efforts, things may go awry. For instance, you may end up with a tenant who doesn’t pay rent or is constantly late on their payments. Or, your tenants pay on time but don’t take care of the property, so when they move out you end up paying more to repair the property than before you can put it on the market.
What this all means is that investing in rental properties is a long-term effort and not a get-rich-quick scheme. It requires patience, some learning on the job and being aware of potential risks. If you’re willing to put forth the initial money and effort, you could be well rewarded.
How to buy a rental property
For those who have decided that investing in rental properties is for them, here are the general steps to take, which include securing financing, finding a great property and hiring the right professionals to help repair and maintain the property.
1. Determine the type of property you want
There are many different kinds of rental property, each with different ways to earn income and methods to maintain them. It’s crucial you take the time to understand the different types so you can know how to move onto the next steps to purchase your next rental property.
The table below offers an overview of each rental property type. It may be a good idea to consult a professional to determine what’s needed to increase the chances of success with each property type.
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Most novice investors tend to choose this type, and it’s the most popular type of rental property. Single-family homes are one unit, typically detached buildings and most commonly rented by families or multiple people who want to live in one household. |
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These buildings have several units — think duplexes, triplexes or apartment buildings. Investors will need more cash upfront but can receive multiple streams of income in return. |
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Vacation or short-term rental homes |
Think AirBnb and VRBO, where you rent a property out to tourists or those looking for a contract with shorter term commitments, like several weeks or months. These properties are typically located in touristy areas or locations with lots of amenities nearby. |
2. Secure financing
The type of financing you’ll need will depend on the type of rental property you want to purchase. Whatever the property, it typically is different from taking out a mortgage for a primary residence.
You’ll most likely have to put a larger down payment and meet different criteria, such as:
- Higher minimum credit score requirements.
- More documentation may be needed such as proof of income, bank statements and tax returns.
- Up to six months worth of mortgage payments in a reserve or escrow account.
- A 20% to 25% down payment.
Keep in mind that interest rates for purchasing investment properties may be higher because of the risks posed to lenders. There are also different financing options available, such as through conventional lenders or through private sources. Consider the pros and cons of each choice before deciding.
3. Choose rental property
The most important factor when deciding whether to purchase a certain rental property is its potential for profitability. Even if the building is in a desirable location, it won’t matter if you’re not able to earn enough cash to cover your expenses.
You’ll also want to consider properties that have a high chance of being rented out — it will help keep income coming in and making your investment more profitable.
Here are some factors to consider when selecting a property:
- Declining vacancy rates
- Historical and projected rental prices
- Percentage of renter-occupied properties
- Job and population growth
- Changes in home values
- Property tax rates
- Whether the property already has a tenant living there
While you can look at online marketplaces, they may not have properties listed specifically for those looking beyond just a primary residence. You can start there, but it may be worth seeking out a real estate agent or professional to help you look for suitable properties. These professionals may also have access to private investors or those looking to sell properties that aren’t listed yet.
4. Go through closing process
Once you’ve found a property and successfully negotiated a purchase contract, it’s time to finalize funding. The timeline for this step may differ depending on factors such as whether you’re securing a conventional mortgage, any contingencies you or the seller may have to meet, and any potential delays.
At this stage, it’s best to keep in touch regularly with your real estate agent (if you’re working with one) and the lender so you’re ready to provide documentation or additional information to help prevent delays.
5. Hire the right people
Before you rent out your property, you may need to update or renovate the property. Depending on what you need, that could be a contractor or interior designer. Interview a few and ask for recommendations before deciding on who you’ll go with.
If you’re looking to make your rental property even more of a passive investment, you may want to hire a property manager. This person or company will take a percentage (or a flat fee) of your rental income, so take the time to find one you trust.
How to make money off your rental property
Making money off your rental property means managing it so that it’s as profitable as possible. It means in addition to finding a “great” rental property by assessing location and amenities, you’ll need to account for the costs that come with maintaining it.
For instance, common expenses that will affect your profitability include:
- Property management fees
- Leasing fees
- Property taxes
- Insurance
- Mortgage payments
- HOA fees
- Landscaping
- Pest control
- Repairs
- Maintenance
- Utilities (depending on what you agreed to in the contract)
You’ll also want to account for the time you screen tenants, unless you’re hiring a property manager to do it for you.
All of the above expenses are reasons why it’s so important to keep track of your operating expenses so that you’re spending less than what you earn on rental income.
While it may be possible to use a notebook or spreadsheet to do so, it may be a better idea to purchase or subscribe to accounting software. There are many specifically geared towards rental property owners that can also keep track of other things like tenant applications and profit and loss statements.
A general rule of thumb on making money with rentals is that your operating expenses shouldn’t account for more than between 35% to 80% of your gross rental income. For instance if your rental income is $2,000 per month, it shouldn’t cost you more than $700 to $1,600 per month.
Risks and challenges to investing in rental property
As mentioned previously investing in rental property isn’t a totally passive type of investment.
There are also risks or challenges you may have face, such as:
- Property maintenance: Even though the tenant is living there, you’re ultimately responsible for the property. It does mean you’ll need to maintain the property, whether that’s making small repairs, replacing systems and appliances that have worn out, and other construction and landscaping upkeep.
- Tenant issues: You may have to deal with tenants who pay late, miss payments, or worse, deal with legal issues and property damage.
- Vacancy periods: There may be times when you can’t rent out your property and it sits there for months, which could eat into profitability.
- Increase in expenses: Sometimes increased costs are out of your control, such as a rise in property taxes.
Tips for investing in rental properties
Though not exhaustive, here are some tips to consider as you’re starting your journey into investing in rental properties:
- Unless you want to spend a lot of time managing the property, it may be a smart idea to hire a property manager and factoring their costs when pricing your rental
- Try to find properties that aren’t necessarily on the market as you may have more negotiating power
- Work with a reputable real estate lawyer when drafting documents, such as purchasing the property or when having a tenant sign a lease agreement
- Have a plan when you face financial losses
- Start with one property and learn as you go before deciding to purchase additional ones
Alternatives to investing in rental property
If you’re not interested in the time or effort it takes to purchase and maintain a rental property yourself, there are other options including:
- REITs: Real estate investment trusts like RealtyMogul are where you earn a return from a company that owns and manages real estate. Think of them like you would invest in a stock, where it’s much more passive compared to purchasing and maintaining a property yourself.
- Partnering with someone: If you’re not confident going out on your own, consider partnering with a real estate investor who has more experience. You can get as involved as you want, or simply offer them investment capital and earn a return while the partner does the more active work.
- Renting a room in your home: Going this route can earn you some money which can help lower your housing expenses.
