Buying your first rental property is an attractive prospect. Invest in a property, fix it up a little to justify top rental rates and check your bank account from the beach.
That’s a fantasy, experienced investors and real estate experts say. Being a landlord is a lot of work. Finding good properties requires diligence, smarts and a firm grip on the finances. Once you get the building ready to rent, you must secure reliable tenants. Then, you’ll either have to manage the building or pay someone to manage it for you.
There’s nothing passive about this form of investing. But if you can do it successfully, investing in small rental properties is a proven way to build long-term wealth.
Understanding the concept of buying rental property
From the little house down the street to a strip mall to an office building, the basic principles of real estate investing are the same.
Well-positioned, well-maintained properties attract tenants that pay market rates, on time. A properly structured investment yields income that covers the cost of the mortgage, operating costs and a fund for capital improvements. You might even gain free cash flow that results in taxable income. Eventually, when you sell your well-run property at the right time, both the physical structure and its rental history become assets that justify a solid valuation. After you sell the property, you will have to deal with capital gains and other tax considerations.
Legal considerations in rental property operations
From start to finish, you must comply with a welter of laws, including building quality and nondiscriminatory lending to unforgiving tax regulations. Before you plunge into real estate investing, line up an experienced real estate lawyer and an accountant who is well-versed with real estate investing management and tax rules. Be sure to keep meticulous records. Your tax accountant and insurance agent will rely on those records.
Investing in different types of rental properties
At a basic level, there are two main types of rental properties:
Commercial properties
Commercial rentals are occupied by businesses, ranging from offices to stores. Commercial rentals can also be occupied by things, such as storage units used by households and small businesses, and, on a larger scale, warehouses and distribution centers.
Historically, commercial properties have been safe, low-drama bets. But in 2024, the post-pandemic real estate economy has posed challenges for commercial rentals, according to a January report by JPMorgan Chase.
Downtowns and suburban shopping areas are on slippery footing as consumers spend more money online. Office buildings echo as workers telecommute, at least part-time. And high inflation has dulled consumers’ appetites for eating out.
Residential properties
Meanwhile, residential rentals, occupied by people, have been propelled to the forefront.
After all, people have to find a place to live. The high cost of buying a first house, as shown in the following chart, translates to high demand for long-term rentals.
Location: A decisive factor when buying rental properties
Convenience, safety and neighborhood characteristics are basic factors of a property’s location. But, of course, each tenant will have their own definition of those factors. A family with school-aged children will likely prioritize access to a top-quality school, while a tenant who travels for work might pay more to be near a big airport. The location of a property will partially dictate the type of tenants it will attract and how much they will pay for the convenience, safety and characteristics they value.
Securing finances for your rental property
Just as you would for your primary residence, securing finances for your rental property is key.
- Provide a down payment: You’ll need to show a mortgage lender a down payment and proof you can pay back the loan. The down payment rule of thumb for a rental property is 20%, said advisors.
- Make a budget: To support your cash flow projections that validate your ability to fulfill the loan payments, you will need to show a budget for immediate improvements; the monthly rental income that you will get for those improved units, based on current market rates; monthly operating costs, including annual expenses like insurance, prorated per month; and how much money you will have in reserve to handle emergencies.
- Consider cash flow: The seller should be able to provide an organized and documented statement of rent cash flow and monthly costs. Be sure to contact vendors to confirm the current costs for utilities, maintenance and the like. Ask the property inspector to forecast when you will probably have to replace appliances, windows, HVAC and renovate the bathrooms and kitchens, if you are not doing so when you take over the property. The maintenance and renovation schedule is integral to your cash flow.
Affordable ways to buy rental properties
The rules for buying a residential rental property are different than those for buying your own house. Interview a variety of lenders to understand their basic and variable requirements.
Secondary mortgage lender Fannie Mae offers a detailed toolkit for learning how to buy rental properties with mortgages through lenders that participate in its nearly universal programs.
The guide spells out exactly what kinds of properties qualify for Fannie Mae-insured loans — a one to four unit investment property, or a two to four unit property that includes one unit occupied by the borrower — and outlines essential documentation and accounting procedures for properly tracking rental income, expenses and some related tax issues.
Even if you project that the building will pay for itself with rental income, the lender will still require verification of your employment and income. And if you pool resources with family or friends to assemble a down payment and share the responsibilities and potential profits, always structure the terms with a real estate lawyer.
What does it mean to buy property with no money down?
Jack Miller is a strategic financing advisor with Real Estate Bees, a network of real estate professionals, and has run a real estate lending company for over three decades.
One way for new investors to gain a toehold in the market is to partner with experienced investors in a sort of apprenticeship, he said. Assisting an established investor with paperwork, vetting properties and working networks of property owners to learn early of properties that might be coming on the market is the lowest-risk way for a newbie to gain operating knowledge. (Be wary of weekend workshops and real estate gurus with guaranteed “formulas” for fast entry and even faster real estate properties, Miller warned.)
“You have to learn to do a deal,” he said. Once you have helped with some deals, you will be qualified to work directly with investors who bring money to match your effort, thus enabling you to get into the market with little or no cash of your own to invest.
You’ll also observe how others get into trouble, often by overestimating their abilities to manage the properties, he said. And, Miller said, be sure to keep your household finances separate from the investment cash flow and management. If you do put some of your retirement savings into rental properties, always work with a tax accountant and financial advisor to assess and contain the risk.
Drafting a contingency plan for rental property vacancy
The heartaches of family bankruptcies and financial losses due to the real estate meltdown of 2008 might seem like distant history for today’s millennials and Generation Y investors dazzled by the rocketing property values of the past four years, said Matthew Kidd, a certified public accountant (CPA) and partner with Blunden & Kidd Accounting & Consulting, who often works with individual real estate investors. Those memories are still painful for Gen Xers and baby boomers who were burned by seemingly solid real estate decisions.
Today’s chronic short supply spells a different set of risks for today’s real estate investors, he said, but some traditional wisdom still applies. Be sure to have several months’ worth of operating expenses set aside in an emergency fund in case a tenant quits paying and you are without their rent while evicting them. If you are investing for the long haul, a temporary pause in the rise of market values is not likely to affect cash flow but could affect your improvement schedule. And, pointed out Kidd, “Property taxes don’t go down with the value of a house.” Some costs are fixed regardless of the current rental or property value trends. A substantial cushion will buoy you through market downturns and ensure that your properties remain desirable to the kinds of tenants you must have for consistent cash flow.
Assessing the financial commitment of a rental property
Your time, energy and the emotional commitment of being a landlord is no small factor, said Kidd, who often works with individual real estate investors.
“Compare the rate of return to what you’d normally get in the stock market,” he said. “You may end up with a variance where the rental income is greater, but how much time will you put into it? Is the greater rate of return worth the effort? Is it a great return on your time?”
“Sweat equity” requires an investment of your sweat, he pointed out. If you can make additional income by taking on a side gig or working overtime, you might net more money with fewer headaches overall.
Frequently asked questions (FAQs)
You will have a financial stake in the property and legal risk, as you are responsible for both the physical property and the foreseeable experience and safety of the people living in it. You must comply with fair housing regulations and ensure that you respond promptly to health and safety issues. As well, you must monitor the contribution — or drag — of the property on your overall portfolio and financial stability.
Property taxes must be paid in full, hopefully from operating cash. As well, you must keep tabs on the long-term implications of the property’s value on your overall portfolio. Your accountant can help you understand if it is advantageous to sell the property at a loss or gain, depending on other investment gains and losses you are experiencing.
The Internal Revenue Service (IRS) has strict rules for how much time you can spend in your own vacation home before disqualifying it as a rental property (short answer: 14 days or 10% of the total days you rent it to others). If you are thinking of buying a vacation home that “pays for itself” through rental income, thoroughly vet the financial and other risks with an experienced tax accountant and with your financial advisor.
