10 Things You Need to Know Before Buying Your First Rental Home

Ready to jump into real estate investment and buy your first rental home?  The gyrations of the stock market in August 2015 certainly is bringing other forms of investing to the top of people’s minds.  Investing isn’t an “all-in” thing, or it shouldn’t be.  Diversification is the advice most stock market brokers give, but they’re just telling you to diversify among stocks, companies and industries.  They’re definitely not wanting you to take money out of the markets and move it into real estate.

I’m not suggesting that you dump all of your stocks and bond holdings to buy rental real estate, but let’s get into my Top 10 things to nail down in your life or think about before you take the leap.

Number 10:  During stock market corrections or crashes, rental property owners just sit back and collect rent checks.

When you put a rental single family home into service, you’re placing a tenant with rent carefully calculated to yield positive cash flow each month after all costs and the mortgage payment (called debt service in the biz).  A massive correction in the stock market doesn’t damage your property, and it doesn’t increase your ownership and management costs.  Well, maybe if your tenant is a stockbroker and jumps off a roof, but not likely.

You continue exactly as before any stock market gyrations, banking your positive cash flow each month and unless real estate also makes a correction, your investment’s value doesn’t change either.  You simply feel badly for your friends and neighbors who are seeing their portfolios drop dramatically.  Problems in August of 2015 with China wiped out the entire year’s gains in the Dow.  Ouch!

Number 9:  There is risk in every investment, including real estate.

I’m not suggesting that there isn’t risk in real estate rental property investment.  However, it’s different in many ways from the risk factors in stocks and bonds.  Let’s look at stock market risk factors for a minute:

• Market risk:  This is when the entire market drops for reasons not necessarily related to a single company’s performance, or even the performance of an entire industry.  The August 2015 corrections were related to problems in China, and they definitely took their toll.
• Company risk:  If you own stock in a company, there can be management or market problems that can take the stock down in value in a big way.  Even if it holds relatively stable, a long period without any rise in asset value isn’t fun either.
• Inflation risk:  If you’re managing an 8% annual return on your stocks, including dividends, it’s going to be heavily damaged if inflation rises to half that pace or higher.  
• Interest rate risk:  Higher costs of borrowing can damage a company’s ability to borrow and cause their stock price and dividends to suffer as well.  Whole industries that rely on borrowing can take a dive when interest rates increase.

As for bonds, here are some risks and points to remember:

• Returns on bonds are generally not very high, especially if you want some safety and less risk.  Government bonds pay a tiny rate compared to the growth you may be able to get in stocks.
• Inflation risk:  This is particularly damaging to the lower returns paid by bonds.
• Interest rate risk:  It is true that unless a company defaults, you’re going to get your entire investment back at bond maturity.  However, if you need to sell it before it matures, and if interest rates have risen, you’re not going to be able to sell it for what you would get if you held to maturity.

Rental property isn’t as damaged by inflation in many cases.  You see, if it costs more for labor and materials, then generally the cost to buy a home goes up, and your rental property’s value will go up as well.  As for interest rates, you should have a fixed rate mortgage, so you’re not too worried.

Number 8:  You need to study your market and the local economy.

Yes, there are full service rental property companies that do all of the work and simply sell you a home, sometimes with a new tenant installed.  If you take this route, it can be good for you.  However, anyone between you and the deal must get a return on their investment and make a profit.  So, you’ll be paying top dollar for the home, and you’ll have to hold it longer to get your money out of it after sales costs.

So, the better approach is to locate your own rental property deals and buy them either from a real estate investment wholesaler or a fix & flip investor.  They understand that a sharp rental home buyer wants to buy at a discount to current market value, so they structure their purchase, transaction costs, rehab costs and profit so that there is some discount left for you.  However, don’t rely on them to do your homework.  

Pay attention to the local economy.  Try to make sure that no major employers are planning on leaving or that there isn’t negative news or development issues that will depress home prices or cut the demand for rental homes.

Number 7:  Know your abilities, financial and time available.

You don’t need a lot of cash to invest in rental property, as you can leverage with a mortgage.  However, if you’re trying to get started with your car repair emergency money, it may be the wrong time to do it.  

To get the maximum return from a great purchase deal and tenant selection, you will need to put some time into this investment.  It’s not the same as calling a broker and placing a stock order.  If your family and current job commitments are extensive, you may want to pass up real estate right now.

Will you be able to handle the headaches of landlording?  Collecting late rents, eviction, and repair calls in the middle of the night are all part of the deal.  After you’re successful and you own multiple properties, you may hire professional management.  But, right now you will be doing it all.

Number 6:  Stick close to home.

This one is debated a lot.  Some of the very best deals these days are in cities like Detroit.  However, if you live in Oklahoma, trying to buy right and manage a rental property in a city far away is probably not the right path.  Later maybe, but not for your first.

You want to invest if possible in your city so that you can drive by your investment a couple of times a month just to see how the exterior looks.  It’s also kind of nice to see your investment sitting there, unlike shares of stock sitting in your broker’s safe or on a computer somewhere.  You also can check out repairs and major issues and shop for the best service to correct problems.  Then you can check quality before paying the bill.

Number 5:  Know ALL of the costs.

Let’s forget for a moment about buying right or even setting rents.  Know that there are costs involved in rental property investment, some fixed and many variable.  Your mortgage is usually your highest cash flow out, and it won’t change if you got a fixed mortgage.

However, property taxes can change.  Unexpected repairs happen.  Advertising for new tenants is part of the deal.  And, you really need to understand that “vacancy cost” is one of the biggest damagers of profit.  If you lose a tenant and can’t fill the home again for two or three months, you could be in a negative cash flow position for the entire year.

Number 4:  Think about the tail end as much as the front end.

Many new rental property investors put a huge amount of effort into learning the ropes to cut a great discount deal on a property that will cash flow well.  Where they sometimes fall short is not thinking about when they sell the home; and you will.  

If you bought right at a discount, you’re still likely to have to hold the property for at least four to five years to be able to make a sale profit after holding costs and closing costs.  Try to buy in neighborhoods that have a history of above average value appreciation.  At least if your situation requires a sale sooner than expected, you want to walk away with a check, not write one at the closing table.

Number 3:  This is a competitive business.

Real estate investing has been booming ever since the real estate crash that began in 2007.  In fact, even the government has credited investors with helping markets and prices to stabilize by buying in quantity.

You can’t just sit back and wait for a real estate agent to bring you a deal.  That’s retail buying, and you want to buy at wholesale.  You need to be actively searching for deals everywhere you go, even driving around looking for FSBO, For Sale By Owner, properties.  Get educated and learn how to run the numbers and be ready to make a decision if the numbers work.  Because, if you see a deal, you can bet that one or more other investors are eyeing it as well.

Number 2:  This isn’t “get rich quick,” but it is get rich steadily.

The tax advantages of rental property are better than any enjoyed by stock market or bond investors.  Ask your accountant and they’ll likely verify that you will not have to pay tax on all of that great cash flow due to depreciation and deductions.

Building a portfolio of real estate and growing its value over time is made even easier by using the IRS 1031 Exchange Rule.  Talk to an accountant, as it’s complicated, but simply:  you can sell a rental property and roll all of your gain into another one without paying current capital gains taxes.  Keep rolling up to higher value properties, and you can build wealth with real estate on a grand scale.

NUMBER 1:  This ain’t rocket science; you CAN DO IT!

The information you need is available, and the money you need is flexible.  Really all you need is the desire and a careful nature.  Sure, you can be a big time real estate mogul someday, but today for your first deal be cautious and learn the ropes for success.