The beginner’s guide to investing in rental properties

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If you’re thinking about investing in the rental housing market, you might be wondering where to start. Like many new investors, you probably have an optimistic view of your new investment property: reliable tenants, passive income, and eventual financial freedom. But how do you get there from where you are now? Like everything else, you start with the basics. Understanding even the rudimentary principles of rental real estate can help you jump-start a successful investing career.

This includes knowing the types of properties, return on investment, mortgages and the legal steps to acquire a property. The research you do upfront can help you avoid a misstep that could sink your investment. Here’s how to start investing in rental real estate:

Related: 5 Tips For New Investors Who Want To Make Money From Real Estate

Deciding Between Residential and Commercial Property

Before buying a property, you need to decide whether you want to buy residential or commercial property. Both types can help you reach your ultimate passive income goal. However, they have some important distinctions.

  • Residential real estate: Residential real estate is property that you rent to someone who is looking for a living space or primary residence. Your tenant(s) may be a family, a student, a young professional or someone else. Residential properties generally have lower start-up costs. Residential mortgages are also easier to obtain, as banks tend to accept lower credit ratings than they would for commercial loans. There is also a higher demand for residential properties, so it will be easier for you to fill your units.

  • Commercial real estate: Commercial real estate is property that you rent from a business. The company could use the property for commercial, office or industrial purposes. Commercial properties require commercial mortgages, which are slightly more complex than their residential counterparts. In some states, buildings with more than five units are automatically classified as commercial properties for tax purposes. Ask a mortgage officer in your state whether this rule or a similar rule applies.

Property value assessment

Now that you’ve selected a property type, you need a few options. Perhaps you have chosen a neighborhood or a few properties that you are considering. How do you know which is your best shot financially? Here are two crucial factors to consider when assessing property value:

  • Location: Location means everything to potential tenants. Is the property close to commercial areas, walkable from downtown, or otherwise in a convenient location? These factors make ownership more desirable and justify higher rental prices.

  • School districts: Position within a top school district influences value more than you might think. In fact, school districts are one of the biggest determinants of tenant and buyer demand and, therefore, return on investment. Good school districts attract young families who are willing to look beyond the inconvenience and pay more for a high-quality education for their children.

Related: Getting your feet wet in the real estate rental business

Follow the 1% rule

Qualitative factors are one way to measure ROI, but you also need to have numbers to back up your assessment. Will the property generate regular rental income? Or will the property ultimately require more time and money than it can earn you? Fortunately, there is a rule of thumb for assessing the soundness of an investment that you can apply before making it.

The 1% rule argues that if you can reasonably rent a property at a rate equal to one percent of the original mortgage, it is likely to be profitable. You need to know if the rate you calculated is reasonable based on demand and rates for similar properties in the area.

Let’s say you buy a duplex for $310,000. You pay a deposit of 25%, or $77,500. That leaves you with a mortgage of $232,500. One percent of that remaining mortgage is $2,325, half of which is $1,162.5. If you can rent both duplex units for around $1160, the property is probably a good investment.

The 1% rule is a quick tip for assessing the potential of an investment. However, this should not be taken as a definitive verdict. The strength of any investment depends on many factors, including your current cash flow, property condition, property tax rates, location trends, and other factors. The 1% rule will put you in the ballpark, but do your due diligence.

Finance your property

Finally, you have chosen a property. If you’re like most investors, you’ll have to borrow money to buy it. This means finding a mortgage lender, negotiating the terms and making a down payment. Let’s break down the types of mortgages, down payments and interest rates:

  • Types of mortgage: There are many types of mortgage loans. The two most common are fixed rate and adjustable rate mortgages. Fixed rate mortgages have a fixed interest rate for the life of the loan, while adjustable rate mortgages have an initial fixed rate that changes as the loan ages.

  • Installments and interest rates: In addition to choosing a type and term of mortgage (15 years, 30 years, etc.), you will also need to put down a significant down payment. Larger down payments will help you get lower interest rates because your lender is taking on less risk. Conversely, smaller down payments come with higher interest rates. Down payments of around 20% are generally considered sufficient.

Related: How to get the most out of your rental property investments

Legal checklist

As a buyer, it is your duty to anticipate a purchase before problems arise. Here’s what you need to do to make sure your investment is properly protected before making it official:

  • Check the title deeds: A title deed, transmitted in an authentic deed, confirms the ownership of a property. Before signing a purchase contract, consult the last deed on file and verify that the seller is the current owner. This can be done through a title company or a lawyer. Next, check the privileges on the property. Liens are claims on a property placed by a lender while the owner still owes money. Ownership cannot be transferred if there are active liens on it. Finally, the title deeds must be signed by both the seller and the buyer (you) to officially transfer ownership.

  • Purchasing title insurance: Title insurance protects you if something unsavory, like an undetected lien, is discovered after the title has been transferred. Some lenders require it to get a mortgage. Title insurance is usually around $1,000.

  • Confirm property tax receipts: Next, confirm that the previous owner has paid all necessary property taxes. Request receipts directly from the seller or request them from your local government tax office.

  • Perform a check: Hire a professional home or building inspector to see if there are any issues you should be aware of before purchasing the property.

  • Sign the property purchase agreement: A real estate purchase agreement is a contract between you and the seller. Like any other contract, it covers the price and all negotiated terms of purchase. Your agent will provide the agreement. Communicate with them about any issues or conditions you would like to see included.

Every successful investor started exactly where you are now. The research and dedication you put in at the start can also help you achieve financial freedom. You are now ready to buy your first property and start investing in real estate.

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