Real estate comes with a lot of benefits, but also potential risks, especially for beginning real estate investors. At Roofstock, we want to make sure your first investment experience is as positive and profitable as possible.
Here’s everything you should be aware of before you buy your first investment property.
You may already know that investment property can provide you with regular monthly cash flow and long-term appreciation. You probably also know that even when you use conservative leverage, you don’t need a lot of money to invest in real estate.
However, there are also a few things to consider that the real estate experts never tell you:
Before you buy your first investment property it’s important to prepare both financially and mentally. Whether you plan on being an active or passive real estate investor, a fix-and-flipper or a long-distance owner of turnkey rental property, be sure to keep these important things in mind:
To avoid investing in a money-losing property, you can use a simple rental property analysis spreadsheet (like this one) to view the potential financial performance of a given property.
2. Unexpected major repair bills:
When you buy a property from a private seller or off the MLS, you run the risk of facing large and expensive repairs. The air conditioning or furnace could go out, or you could have a major plumbing repair that can only be fixed by a high-priced licensed contractor.
To avoid getting caught off guard, set up a capital reserve account for any emergency repairs, or purchase a turnkey investment property that’s been thoroughly pre-inspected and already occupied by a good tenant.
3. Vacancy rate higher than planned :
Sometimes, due to local market conditions, it can take longer than expected to find a qualified tenant. In the meantime, items like landscaping, property taxes, and the mortgage still need to be paid.
When you put together a pro forma financial statement on your first investment property, try ‘stress testing’ it by experimenting with different vacancy rates. Creating different vacancy scenarios will give you a good idea of how much cash you’ll need to hold in reserve if the property sits vacant longer than expected.
Some beginning real estate investors go “all in” when they buy their first investment property. They scrape together every dollar they have, borrow from friends and family, while leaving nothing in reserve for a personal emergency fund.
While some real estate gurus on TV may encourage you to do just that, the problem is that ‘life happens’ and something could go wrong when you least expect it, forcing you to sell your first rental property at the worst possible time.
So, think of your personal needs first by having 6-12 months in savings, and contributing to an IRA or 401(k). You’ll have the advantage of tax-deferred savings, and as an extra bonus you can set up a self-directed IRA for investing in real estate, allowing you to build a tax-sheltered investment property portfolio.
2. Strengthen your credit score:
Most lenders require a credit score of at least 740 in order to give you the best rates and terms for a mortgage on a residential investment property. High credit card balances should be paid down, and ‘dings’ on your credit report should be taken care of before you apply for a loan and make an offer on a rental property.
3. Build your business cash reserves: When you buy your first investment property you’ll need to have money for the down payment, escrow fees, legal fees, and closing costs, and repair or renovation expenses if you’re not buying a turnkey rental property.
If you are financing your purchase, some lenders will also require you to hold six months or more of cash in reserve. That way, the bank knows you’ll be able to pay the mortgage in case there is no rental income due to a higher than expected vacancy rate.
Real estate is arguably one of the best investments you can make, provided you follow the right steps:
Attempting to manage an investment property on your own takes a surprising amount of time and money. The most successful real estate investors hire a professional property manager to oversee the daily details of each property.
If being a landlord isn’t for you, you can always invest in real estate indirectly through a joint venture, crowdfund, or a REIT.
Credit cards, medical bills, and auto loans can take a surprisingly big bite out of your personal cash flow. While some debt isn’t always avoidable, you don’t want to be in a situation where you have to choose between paying the loan on your investment property or a credit card.
Lenders usually require a bigger down payment for an investment property. There are a couple of advantages to putting more money down.
First, you’ll receive a better interest rate and loan terms. Secondly, you’ll have more free cash flow due to a lower mortgage payment. In most cases, using a conservative LTV ratio (loan to value) of 75% by making a 25% down payment gives you enough equity and cash flow to generate a healthy and safe return on your investment.
In addition to your down payment and closing costs, you’ll also need to hold cash in reserve for unexpected repairs or reduced rental income due to a higher than normal vacancy rate.
You can build up your reserve account over time by contributing a fixed percentage of your cash flow each month into a special capital reserve account.
Your first investment property doesn’t have to be in the same city that you live in. In fact, there are plenty of real estate investors who live and work in high-cost markets but invest long-distance.
The Roofstock marketplace is a good place to look for single-family and small multifamily rental properties in attractive markets across the country.
Even though the housing market is still going strong, there are plenty of good investment properties on the market priced at less than $100,000.
Sometimes, you’ll need to move fast to get the best deals. If you decide to pay in cash (or make an extra-large down payment to speed up your loan approval) you can always refinance at a later date to pull out some of your original cash.
If you are financing, you’ll need to get pre-qualified for a loan before you make an offer on an investment property. Items you lender will look for include:
Finding and buying your first investment property is much different from buying your own home. You’ll need to develop a real estate team made up of professionals who understand how income property works.
Key members of your local real estate team can include a real estate agent who works with investors, a local lender and attorney, and a good property management company with an established network of cost-effective service professionals.
Some markets are better than others for investment property. Factors that make a place “good” for rental property include:
If you’re looking for some extra help on selecting a market, listen to this recent podcast episode where our team does a deep dive on this topic:
After you’ve narrowed down a market to invest in, the next step is to analyze the potential financial performance of several investment options. By comparing different properties to one another, you’ll gain a better feel for which property is best for you.
Start by creating a proforma statement for each property. Begin with the property gross income, then subtract the vacancy and bad debt expenses, recurring operating expenses such as landscape and maintenance, property management fees, and your mortgage payment to arrive at your net cash flow.
Other calculations you can use to analyze the potential financial performance of each rental property include:
You can read books and listen to podcasts until you’re blue in the face, but at some point, you’ll have to take the leap and make that first offer.
Many first-time investors choose to buy a turnkey property, meaning the property has been recently rehabbed and is rent-ready. In fact, many of the properties (like the ones listed on Roofstock) already have the tenant in place so you have cash flow on day 1.
You can also always choose to take on a rehab if you feel comfortable taking on a project.
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There are an almost countless number of benefits to owning investment property. Tenant rents pay for your operating expenses and mortgage, with any remaining cash flow left over as profit. Property depreciation can then be used to reduce your amount of taxable net income, sometimes even to zero (even though you actually earn a cash profit).
Investment real estate is also a great way to diversify your investments, save for retirement with a self-directed IRA for real estate, and build your wealth over the long term. Of course, each advantage comes with potential drawbacks as well.
In order to make your first investment property as profitable as possible be sure to:
This article, and the Roofstock Blog in general, is intended for informational and educational purposes only, and is not investment, tax, financial planning, legal, or real estate advice. Roofstock is not your advisor or agent. Please consult your own experts for advice in these areas. Although Roofstock provides information it believes to be accurate, Roofstock makes no representations or warranties about the accuracy or completeness of the information contained on this blog.
Jeff has over 25 years of experience in all segments of the real estate industry including investing, brokerage, residential, commercial, and property management. While his real estate business runs on autopilot, he writes articles to help other investors grow and manage their real estate portfolios.
