How to Buy a Rental Property

Aparna Iyer Jun 10, 2019
Tap to Read ➤
Investment in a rental property should be undertaken after considering the expected cash flow from the property, the purpose of investment, and a number of other factors, that are mentioned in the following write-up.
Rising unemployment due to recession has resulted in a number of people losing their home because of their inability to make mortgage payments. This has forced people to move into a rental apartment in their quest for cheaper accommodation. Considering the present scenario, investing in a rental property may not be a bad option.
In the US, rental properties can be classified into five categories: mobile homes, condominiums, properties with 1 to 4 housing units, properties with 5 to 49 housing units, and properties with more than 50 housing units. Before buying a rental property, the given factors should be considered.

Goals

The type of property to be purchased would depend on whether the person is looking for a long-term or a short-term investment. A long-term investment would mean a steady stream of income from the property in the form of rent.
Hence, one can afford to buy an expensive property because the probability of rent appreciating long-term is much higher than in the short term. A person who intends to hold the property for a short period of time and sell it for a profit, should go for a cheaper investment.

Location

Location is an important factor which needs to be considered before investing in a rental property. A good location is characterized by the proximity to schools, parks, and stores. The neighborhood should also be safe. The best way to locate such a neighborhood is through a real estate agent or a broker.

NOI and Cap Rate

The net operating income (NOI) and return on investment (ROI) can be calculated using these formulas:

Gross Rent - Vacancy Charges = Gross Operating Rent
Gross Operating Rent - Operating Expenses + Operating Income = Net Operating Income
Operating expenses include charges for repair and maintenance, taxes, insurance premium, management fees, and legal fees. Operating income includes late fees, parking fees, income from vending machines and so on.

Capitalization Rate = NOI/Fair Market Value of the property (FMV).

The higher the cap rate the better is the investment.

Appraisal and Inspection

Having the rental property inspected and appraised is the next step. Inspection helps us decide whether the property is in good shape, while appraisal helps determine the fair market value of a property. Generally the FMV of the property is calculated by dividing the NOI by the Capitalization Rate for similar properties in the neighborhood.

Financing

There are 4 popular ways of financing a rental property:
Mortgage
Mortgage from a bank is a feasible option for a person who is able to fund between 20% and 30% of the value of the property. People who are able to fund up to 30% of the property's worth get the best deal on interest rates. The reason banks require a down payment for purchasing the rental property is because they consider it a risky investment.
A person is more likely to default on the rental property mortgage payment than a mortgage payment on his home. A person needs to have a really good credit score in order to borrow from the bank. In the present scenario, a credit score in the range of 700 to 750 can get a person a really good deal on the mortgage.
Seller Financing
Seller financing is an option for a person who would prefer down paying around 10% of the value of the property. The seller can then finance another 10%. The remaining 80% is financed by taking a mortgage from a bank.
A seller might be willing to finance the deal because financing provides him the flexibility of deciding when to sell the house or how long to occupy the house before vacating it. Moreover, the seller gets a greater return from this investment as opposed to the return he can hope to get by investing in a Certificate of Deposit.
The buyer benefits because the seller charges a low rate of interest as compared to the bank and allows him to pay only interest for 60 months. At the end of 60 months, the buyer pays a lump sum amount as a balloon payment.
Rehabilitation Loan
Rehabilitation loans are a must in case of buying a foreclosure. The loan, as the name suggests, is used for reconstruction, and is generally provided for a period of 6 months by the rehab lender (private lender).
The borrower can extend the loan on a monthly basis for up to 13 months. The lender will generally provide up to 70% of the after repair value of the house or 95% of the cost of the reconstruction project.
The process does not end here. A person would have to consult an attorney and get the necessary papers ready, and negotiate on the price with the seller. One also needs to look for tenants and decide on how to manage the property.
A property manager can be hired to take care of the property or a person may choose to manage it himself. There are a number of property management software available in the market, the use of which will definitely aid the process of rental property management.