The Ultimate Step by Step Guide to Buying your First Investment Property
Why invest in real estate?
Real Estate is one of the safer investments you can make due to its utility, relatively stable value and predictable income stream. Additionally there are 5 major advantages more or less unique to Real Estate that make it a tremendous vehicle for wealth generation.
Leverage is one of the most powerful mechanisms for building wealth; it's the concept of using other people's money, or in this case the bank's money. It's the idea of getting more for less, like when you borrow 80% of the money to buy 100% of a cash flowing property. The low, fixed interest rate and high Loan-to-Value of the mortgage means that you get a larger return on your investment, especially over time as your rents increase and the mortgage payment stays the same.
Cash flow is the difference between the total rental income that your investment property generates minus the operating expenses required to maintain the property. The beautiful thing about cash flow is that it is real cash paid to you, the landlord, by the tenant every single month. That is money that you can use to live and over time if you grow your cash flow basis enough it can completely cover all of your personal living expenses.
The third major advantage is the loan paydown or the amortization of the mortgage over time. One of the hidden advantages of financing a cash flowing property is that every month when you make that mortgage payment, part of that money is going in your pocket by way of principal paydown and equity buildup. So out of a $1,000 monthly mortgage payment you make every month, $200 out of the $1,000 payment you make is going into your pocket as equity.
The fourth advantage of owning real estate which is also a builder of equity is the appreciation of the property over time, whether natural or forced. With the exception of economic recessions and natural disasters, real estate tends to increase over time and in fact over the last 50 years the average price of a home in America has increased sevenfold. You can also force appreciation by making necessary repairs that increase the value of the property because of its increased desirability and livability. This means that you are likely to sell your property for more than what you paid for it.
Real estate investors are entitled to numerous benefits by way of deductions and tax breaks that allow you to save lots of money over time. The tax law allows you to deduct ordinary and necessary expenses for managing and maintaining your rental property. In other words, you can deduct expenses like the interest portion of your mortgage payment, your property taxes, your insurance premiums, maintenance, repairs and depreciation.
Note: Depreciation is the reduction in value of your property over time due to wear and tear; the tax law accounts for the fact that everything in your rental property will have to be replaced and they let you account for that before you even spend the actual money; this is called a non-cash expense.
Now that you understand the tremendous benefits of owning real estate and are intrigued by the wealth-building opportunities that are available to real estate investors, there are several questions that you need to ask yourself.
Questions to ask yourself when buying real estate
Are you cut out to be a Landlord?
This is something that you need to ask yourself and answer honestly because it will be key to your long-term success and quite honestly--your sanity. Being a landlord can be quite stressful if you don’t know what you’re getting yourself into or don’t have the proper systems in place. Landlording can take several forms, such as a hands-off approach that sees a management company oversee the daily operations of the property or a hands-on style of ownership, where you handle everything yourself; hiring for repairs, preparing leases, collecting rents and answering tenant requests or complaints. Either management style will see you spend at least some time overseeing the rental property because even if you hire a management company, you should still have control systems that allow you to understand what is going on at all times. Your investment property is ultimately your asset and responsibility.
Do you know your Legal Obligations?
Landlords have certain duties and responsibilities and there are specific landlord-tenant rules that every landlord must follow. These rules include national and state-wide laws and regulations that govern the landlord-tenant relationship; things such as maintaining a safe environment, and the handling of security deposits are a couple you should become familiar with.
Note: Make sure to research your specific state and local landlord-tenant laws to learn about additional obligations that may exist in your area.
Should You Buy Cash or Finance?
You can choose to buy cash, not involve the bank, not get into debt, bypass the whole mortgage payment expense and own the property outright; it's an option available to whomever can afford it. The advantage of buying cash is that you eliminate the risk of defaulting on your loan and potentially losing the property and your investment to the bank for lack of payment. You also see the elimination of a big expense and an increase in your cash flow.
The disadvantage of buying cash is that it requires more cash at the time of purchase and thus may delay your ability to make your first investment. Additionally, you also lose out on the benefits of leverage and the fixed low-rate mortgage payment. If the investment makes sense, financing the property with a low interest rate will only provide you with better returns and allow you to potentially spread your money across multiple properties. For instance, instead of paying cash for one property you can use that same amount of money and buy two or three properties with the help of the bank.
If you come to the conclusion that you are up to the challenge of being a landlord and want to learn how to make that first investment read on.
How To Buy Your First Investment Property
Determine Your Market
Determine where you want to invest your money and where you want to own a rental property. It could be in your immediate neighborhood, somewhere in your city or even out of state. What you don’t want is to be too far away from your rental property and hate the long commute. You want to be in a market that is no farther than 1.5 hours away. In addition to that you want to pay attention to three metrics in that market before you invest:
Vacancy rate: you want to see a vacancy rate of 5% or less, any higher and it may mean your rental unit will sit on the market for a long time before you can find a tenant
Days on market: you want to make sure that well priced homes don’t take longer than 4 months to sell in the area you choose. A market with a high DOM can mean that there aren’t too many buyers interested in purchasing and might mean you will have a hard time finding a buyer when you eventually sell.
Growing population and good job trends: One extremely important metric in a real estate market is whether the number of potential renters, buyers is growing. An increasing population means that there is a stable tax base to pay for the surrounding public services and infrastructure that are integral to maintaining property value. A dwindling tax base means roadway projects and other public service systems will eventually lack funding. What ensures sufficient tax revenue is the local economy and whether it's an environment where companies and workers want to work in. These individuals are your potential tenants
Secure a Down payment
Learn what rental properties in your area go for, then do the math and calculate that you will need about 20% of that for a down payment. Additionally, save up at least another 4-5% for closing costs, which are transactional expenses that will require you to come with extra cash to the closing table. Lastly, make sure to also have 2-3 months of mortgage payments as reserves; banks like to see this.
Get Pre-Approved for Financing
Once you decide the market you want to invest in, you’ll quickly learn what rental properties sell for in that area and what kind of down payment you’ll need to come up with. After crossing those two off the checklist you need to turn your attention to getting pre-approved for the purposes of getting a loan(assuming you choose to finance and not buy cash). This will require specific documentation and is a precursor to getting an actual mortgage approval so make sure to pay attention during your conversations with your mortgage lender.
Become a Master at Analyzing Properties
Armed with a down payment and a pre-approval means you are ready to find your first investment property and what you need to hone next is your ability to spot a good deal. In order to spot a good deal you need to understand the characteristics of a good investment. The good thing is that the math required to analyze and evaluate a rental property is pretty simple; just basic arithmetic.
Analyze a Lot of Deals
You’ll likely not find the right rental property for a while, expect that it can take 3 months or more to find your first investment property. While you need to be decisive and act fast when you spot a good deal, you should also avoid rushing into making an offer before you’ve seen and analyzed at least 10-15 deals in your market. Unless you spot an absolute bargain and run it by other experienced investors who give you the greenlight to pursue, I would take my time and see what is out there.
Hunt for Properties
At this point you’ve combined your financial power with your knowledge of the market and rental properties and you are ready to go hunting. Pulling the trigger on your first investment property can be both exhilarating and terrifying; don’t be hard on yourself when you find yourself doubting your math or your judgement. Allow yourself to feel the emotions but don’t let the fear stop you and don’t let all those rejected offers discourage you either. Oh yea, you’ll probably fall in love with a property, rush to put an offer in and wait days only to hear that the seller went with someone else’s offer. When this happens keep your head in the game and don’t get emotionally attached to any particular property; remember that you are buying a property to rent out not to live in.
Learn how to spot a good deal
The process of learning how to analyze deals will teach you how to determine a fair value for a rental property based on the property’s income and expenses. And the time you put into hunting and seeing many deals will help you learn the difference between a good deal and a bad deal. In time you should be able to read and eventually prepare an income statement that will tell you the following information about any property:
- Gross income
- Operating expenses
- Net Operating income
- Debt service
- Cash flow
Knowing what these are and how they can affect your bottom line, A.K.A. your cash flow, is key to successful real estate investing. Once you’ve determined that a property has good or great fundamentals and is worth pursuing you can make an offer.
Make an Offer
Making an offer is a key moment in purchasing your first investment property because there are no guarantees that you will get your offer accepted. There are many forces in the marketplace that can work against you such as a weak offer, either because it’s too low, has too many contingencies or lacks the proper documentation to inspire confidence in your ability to close. Make sure your offer letter is separate and clearly states your offer price, your down payment amount, list of contingencies and desired closing date. Additionally, send your pre-approval, and proof of funds(bank statement) along with your offer letter. These are things that your real estate agent can do if you decide to work with a realtor. Otherwise it’s up to you to make sure your offer is strong.
Once you’ve gotten your offer accepted you are ready to enter into due diligence and start the process of eliminating certain risks. First you want to schedule an inspection so that a certified inspector can tell you if there are any repairs that need to be fixed immediately before you can close or rent to a tenant. Being unaware of repairs can result in unanticipated expenses and delays in renting the property out. If there are in fact repairs that need to be made you can renegotiate with the seller to account for the added cost. You should also ask for documentation from the seller to help you consolidate your estimated income and expenses with the actuals. You should also ask to see any leases if the property is coming with existing tenants. Once you’ve gone through this process and you feel comfortable and have not uncovered any issues that throw your analysis off then you can choose to proceed with going into contract and applying for a mortgage.
Get a mortgage and beware of high interest rates
Current interest rates are at historically low levels but still you want to make sure you get the best possible interest rate and APR, which is the rate that takes into account the other costs associated with your loan. The best way to ensure you get the best possible rate is to speak to several banks and lenders to see who has the better loan product for you. You don’t have to go with the lender or bank that gave you the pre-approval so you are free to see how they match up with others. Plus, these conversations are super educational and instrumental in learning an important part of real estate investing--the financing.
Once you apply for the mortgage and get approved for the loan you are ready to close on your first investment property. An appraiser will come out and appraise the property and you will be required to sign and submit a ton of documents. Once these things are taken care of you will be cleared to close and a date will be agreed upon for the closing and at the end of that meeting you will be given the keys and title to your first investment property.
Manage Efficiently, Effectively, and Profitably
Once you find and close on your first investment property you are now left to manage it effectively so that you can realize the profits--which is the reason you did all of this in the first place. Make sure to figure out what management style best suits your goals and lifestyle so that you can properly keep tabs on your property. Most importantly keep learning and keep investing!