9 Things You Should Know Before Investing in Rental Properties
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Elizabeth Pandolfi Contributing AuthorClose
Elizabeth Pandolfi Contributing AuthorElizabeth Pandolfi is an award-winning writer and editor with expertise in real estate coverage, including New Urban and planned communities.
At HomeLight, our vision is a world where every real estate transaction is simple, certain, and satisfying. Therefore, we promote strict editorial integrity in each of our posts.
You’re looking for passive income, you’ve got some knowledge of the real estate market, and you have a bit of capital to invest. Buying a rental property (or several) is just an opportunity waiting to happen, right?
The truth is, as much as real estate investing is touted as an easy way to bring in a regular stream of cash, there are a whole lot of details involved—from finding the right property management company, to knowing how to price your rental—and potential problems that can trip up the eager new investor.
According to data from SmartMove, 54% of apartments turn over every year. That means that you—or your property manager—may have to search for new tenants on an annual basis, and that process usually takes a few weeks to a month if you’re doing any kind of credit or income screening. And that can translate to a month or two of needing to pay your rental property mortgage yourself, without the help of any rental income.
That’s just the tip of the iceberg—before taking the plunge on that fixer-upper in a hot rental neighborhood, get a better idea of what you’re signing up for with this point-by-point roundup we put together with the help of seasoned real estate investors.
1. Rental income won’t be as “passive” as you imagine.
While owning rental properties may provide you with passive income, that doesn’t mean it won’t require a lot of work. Managing that property—fixing it up, keeping it in top shape, dealing with tenants, etc.—will almost certainly take more time and engagement than you expect.
“People think they won’t have to be actively involved,” says Charles Tassell, COO of the National Real Estate Investors Association. “But you have to watch your properties. If you don’t, they’ll be destroyed, they’ll go away, you’ll lose them. Real estate is something you have to be very mindful of.”
“But hang on,” you say. “I’m planning on using a property management company to manage my property. They’ll take care of everything.”
A good property manager will make it easier to manage your rental property. However, not all property management companies are created equal. It’s vital to do your due diligence on local property managers before you hire one, as a bad property manager could cost you a lot more in both time and money than simply managing the property yourself would.
Some of the most common problems associated with poor property management companies include:
- Lax reporting or communication
Not telling you about serious maintenance issues promptly, or failing to report late rents in a timely manner. - Failing to do thorough property inspections
Such as checking the appliances and disposal, taking pictures of damage, and inspecting for plumbing leaks before tenant move-in or move-out. - Using only maintenance vendors that have a reciprocal relationship with the property management company, rather than choosing the right vendor for the job.
Many property management companies have agreements with certain maintenance vendors, which on its own is not a problem—however, if the vendors are not delivering quality work, or the company is getting “kickbacks” (benefiting financially from giving those vendors work), then there’s a chance you’re not necessarily getting the best level of service.
To ensure that you don’t end up with a bad property management company, you should:
- Get referrals for a few different operations in your area.
Ask your real estate agent, fellow rental investors, business contacts, as well as anyone you know who’s currently renting or has rented locally in the recent past.
- Interview the lead property manager in person.
In addition to learning about the company and its processes, pay attention to more subtle details, too. Does the person look and act professionally? Do they seem knowledgeable? Are they the type of person that you could see both yourself and potential tenants wanting to deal with?
- Ask for all the ways the company advertises their rentals.
Do they list them only on their website, or do they take advantage of large rental websites? Are they active on social media? According to the Nationwide blog, about 90% of renters start their rental search online, so it’s vital that the company has a strong online presence.
- Ask to speak to current tenants.
While you can learn a lot about a company from scoping out their website and talking to the property manager, the only way to truly see how they treat their properties and tenants is to talk to the tenants themselves. Ask current tenants whether their maintenance issues are dealt with promptly, whether the property was in good shape when they moved in, and whether they intend to renew their lease and why.
2. Successful real estate investing requires understanding the market on a micro-level.
Maybe the town you live in is glutted with rental properties, or the market is weak. So you’re looking to invest in a hotter market—one that has the holy trinity for rentals: that would be affordability, population growth, and job growth, according to Real Wealth Network, a real estate investment club that helps its members build wealth with income properties and an Inc. 5000 Company.
You’re also looking for markets where you can find relatively low-cost properties (around the $100,000 range) with high cash flow potential (i.e. lots of potential renters).
It’s easy to look up stats on a city like average rent, cost of living, population size, etc. Sites like Apartment List and City-Data are good places to start.
However, you need to go a lot further if you want to make a good investment, rather than end up saddled with a money pit.
“It’s not saying, ‘I’m going to buy in Colorado,’” Tassel says. “It’s not even, ‘I’m going to buy in Denver.’ It’s buying in this submarket, in this neighborhood. Going just a couple of blocks away can change things dramatically, so understanding your market on that micro level is important.”
You’ll want to know the average rent in the neighborhood you’re considering, as well as whether it’s in a good school district, whether the community has amenities like a park or pool, and more.
Doing this right requires making an in-person trip to scout out the neighborhood in person so you can get a feel for the area, see how busy the streets are and how noisy the vicinity is, for example.
An in-person trip will also let you fact-check vaguer qualities like walkability. A property might technically be within walking distance to restaurants or a school, but are there sidewalks, and if so, are they in good repair? Are the intersections calm enough to allow for safe walking?
The more details like this you can get, the better.
In addition, seeking out public records like tax assessments via your county’s tax office is also a smart idea. Many counties offer online portals that allow you to search property tax records.
3. You’ll need professional help.
If you’re considering investing in rental real estate, it’s important to assemble a team you can count on. That includes:
A real estate attorney
Real estate attorneys are invaluable, especially to investors who are new to the game. When you’re considering properties, attorneys can help you evaluate deeds and records, and will be able to spot potential legal issues that you might never have noticed: irregularities in tax history, for example, or a problem with a deed that could lead to issues with either closing the property or eventually selling it.
What’s more, an attorney can help ensure that you’re working from the most up-to-date regulations, says Tassell, because subtle changes in the law can have major implications for your investment.
A property manager
Unless you’re planning on spending a good deal of your time answering tenant phone calls, scheduling maintenance repairs, and collecting rent, it’s a good idea to hire a property management company. Think about it: do you really want to be the person who gets called at 3 a.m. when a pipe bursts?
A contractor if you’re doing repairs or renovations
So you’ve started to renovate the bathroom of your rental property, and just realized you didn’t pull a required permit.
Or maybe you’ve completed a time-intensive DIY project only to realize that something’s not up to code. This is when a specialized contractor would have saved you time, headaches, and potentially legal fees as well. Because contractors are licensed by the state, they have to guarantee that their work meets code requirements.
An accountant
Working with an accountant can be extremely beneficial once tax time arrives. A good one can save you by knowing regulations like the 1031 exchange, a section of the tax code that allows a real estate investor to defer all capital gains taxes by selling an investment property, then reinvesting the proceeds into a new (like-kind) investment property.
Or consider the 2018 tax law overhaul. According to an analysis by the Real Wealth Network, this has given real estate investors the opportunity to claim more deductions, as well as take advantage of a lower tax rate, which could encourage investors to expand their holdings.
A real estate agent who has investment experience
A real estate agent can be a huge asset when it comes to finding good potential rental properties. This is especially true if you’re in a hot rental market, where competition for reasonably-priced investment properties with strong cash flow potential is intense.
“You need to find an agent with investment experience,” says Investment Property Specialist and top-selling Georgia real estate agent Desari Jabbar.
“They’ll know to look for properties on a weekly basis, so that as soon as properties hit the market, they’re showing it to you. Bank-owned properties, short sales—they’re looking for the best deal they can find you.”
Agents can also help you find a tenant for your rental, and help you sell it if or when you decide to let it go.
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4. You don’t need tons of capital to start investing.
Here’s some good news about becoming a real estate investor: contrary to popular belief, you don’t actually need a whole pile of money to get into rental real estate.
While many investors do pay cash, it’s quite possible in most, if not all, markets to get a reasonable financing package for a rental property. Options include hard money loans, in which the loan is secured by real property (these are usually issued by institutions other than banks), or conventional mortgage sources like banks.
Hard money loans can work well for investment properties because they’re specifically designed to be short-term and to help the buyer get the property ready for market as quickly as possible. The lender uses the “after repair value” or ARV, of the property, rather than the applicant’s creditworthiness, to determine whether to grant the loan.
Even with a conventional mortgage, you don’t need to have $200,000 in the bank right now to get into investing. However, you should have some money ready to go.
“You will need a certain amount of money to put down,” says Jabbar. “You do have to have some kind of cushion, because you have to maintain the property. Tenants move in, move out, and you have to be able to pay the mortgage no matter what’s going on.”
According to LendingTree, the down payment usually required for a rental property is between 15%- 20% depending on your credit score.
If, however, you’re buying a multi-family unit and planning on living in the property, you can use an FHA loan, which can require as little as 3.5% down.
5. Managing tenants can be a nightmare.
While every landlord does what he or she can to verify that their tenants are decent, respectable people who will take care of the property, sometimes, you just get unlucky. Take the story of a disgruntled tenant who placed packages of raw meat behind the walls before moving out, leaving behind a horrible stench that required replacing all the drywall and insulation.
If you’re using a property management company, make sure that they have systems in place to vet tenants, verify income, and do a background check for a criminal history. Some companies run credit checks as well to look for things like bankruptcies.
If you’re doing tenant screening on your own, you’ll want to follow these guidelines:
- Require an application that requests information on income, employment, and the number of people who will be living in the property. Sample applications can be found online, like this one from Fit Small Business. The application should also request consent from the tenant to complete a background and credit check.
- Run a background check to look for things like evictions and criminal convictions. These can be conducted through online resources like Experian for a fee.
- Run a credit check to look for bankruptcies and creditworthiness. These can be completed online as well, but you’ll need the tenant’s full name, social security number, addresses for the past two years, date of birth, current employer, and current landlord. These items should be requested on your tenant application.
6. Renters are often as picky as buyers these days.
Some beginner investors in rental properties mistakenly think that renters will take anything—even if the property is in poor condition. With 36.6% of American households renting, according to U.S. Census data, renters are not simply people who can’t afford to buy—32% of those renters are doing so by choice.
In general, these days renters are just as picky as buyers. “Renters want the same thing everybody else has,” Jabbar says. “They don’t want to be stuck with a house that’s going to need lots of repairs, where they constantly have to ask the landlord to do this or that.”
The moral of this story is to make sure that you perform all the necessary maintenance, repairs, and cosmetic updates to your rental property before you start looking for tenants. Not only will this help you find a reputable tenant faster once you do put the property on the rental market, but it will save you many potential headaches down the road.
7. It’s best to find a real estate agent with specific experience in investment properties.
Real estate agents with experience in rental investment properties have skills, knowledge, and contacts that agents who deal mainly in primary residences just don’t.
“Agents who are experienced in investing are the ones going to the real estate investing association meetings, who know the market, who have a good network of contractors and attorneys,” Tassell says. “Word of mouth is one of the best ways to find out who’s good and who’s not, so that network is very important.”
Agents who work with investors regularly will, for example, be comfortable with negotiating, as investing usually involves beginning with lower offers than a typical home buyer would make. They’ll understand their locality on the micro- level, knowing how small shifts in the rental real estate market are affecting neighborhoods, streets, and blocks. They’ll also understand cash flow, ARV, and other considerations that can help them—and you—determine whether or not a certain property is likely to be a good investment.
8. One big maintenance cost can wipe out your profits.
As the Forbes Councils’ Joe Fairless writes in Forbes, rental properties in good condition will usually bring in about a few hundred dollars in profit per month (that is, a few hundred dollars more than your mortgage). “The costs associated with one large maintenance issue or a turnover could wipe out months, or even years, of profits.”
Another issue that many investors come up against is finding unexpected repairs, like outdated wiring, a roof that’s leaking into the attic, or faulty plumbing, during the renovation process, which can quickly balloon the agreed-upon budget. In fact, according to the NerdWallet 2018 Home Improvement Report, 44% of homeowners found themselves having to make an unexpected home renovation within the first 12 months of owning the property.
This is where that cushion of funds can really come in handy. Experts recommend having at least three months of mortgage payments stashed away, according to the Mortgage Reports.
9. Location is important, but it’s really about education.
With the number of bloggers and columnists touting the financial power of renting out property, real estate investing can look like an opportunity to put in a bit of work and make huge profits.
But it’s important to remember that that’s way more likely to be the exception—not the rule. “You really do have to be educated on what you’re doing,” Jabbar says. “It’s not just location, location, location. It’s education.”
One excellent way to start learning is by attending a local real estate investors association meeting. Many beginning investors don’t take this step, and end up learning things the hard way. “I’ll say to someone, ‘What’s your ROI on this property?’” says Tassell. “And they’ll say to me, ‘What’s ROI?’ That’s fine—everyone has to start learning that at some point—but you have to learn those things before you get into it.”
Other rental real estate terminology you should know includes:
- Net operating income (NOI):
The potential of a property investment to be profitable, calculated by subtracting the estimated operating expenses (not including the mortgage!) from the estimated revenue. - Cap rate:
The annual rate of return on a property, calculated by dividing the NOI by the property’s purchase price.
- Gross rental yield:
The total income a property generates, divided by the total amount paid for the property, including closing costs.
If all this overwhelms you, then it’s a sign you need to do a bit more homework before you dive into your first rental real estate investment.
Investing in rental real estate can be a smart decision, as long as you’re ready and willing to put in the work required to make that investment successful. With the right team behind you and a solid knowledge of the market, you can turn those real estate investment dreams into a reality.
Ready to start? Use HomeLight’s Agent Finder tool can help you find a real estate agent versed in investment properties.
Header Image Source: (Abraham Mast/ Unsplash)
