Investing in rental property is a great way to put your money to work for you. This strategy will help you build wealth and income that aren’t dependent on the number of hours you work in the day—the first step toward achieving financial independence.
For more information on how to use real estate investing as a wealth-building strategy, be sure to check out our ultimate guide here.
But, first, it’s important for investors to understand that buying an investment property isn’t the same as buying a house to live in. Failing to follow the right process can actually cause you serious problems down the road.
Don’t believe me? Consider this warning: If you go to buy a rental property and don’t tell your lender that the property you’re buying is for renting up front, they may assume you’re buying property to occupy—or live in—it. As a result, they may have you apply for an owner-occupied mortgage.
If you end up closing on your property using a conventional mortgage designed for owner-occupied property, but don’t actually live in the house you buy, that’s technically fraud.
In this case, you may actually be in extra deep trouble due to property taxes. If you close on an investment property and your title agent designates it as owner-occupied property, your local tax assessor may think that you’ll live in the property and charge you owner-occupied real estate tax rates, which are typically lower than those charged on non-owner-occupied (rental) properties. If you don’t actually occupy the property, you could end up paying the wrong tax rate and be subject to hefty fines and penalties.
This is just one case where the order of operations is important in rental property investment. Following the ten following steps IN ORDER will ensure you find and buy the right investment property and, more importantly, you buy it the right way too!
Here are the steps you’ll need to take to find and buy an investment property:
Decide what type of property you want to own
Before you can start looking for an investment property, you have to know what type of property you want to buy. Each type of property—residential, commercial, industrial, etc.—comes with its own headaches. So, before you start looking, you should know what you’re willing to deal with and what you want to avoid.
Some questions to ask yourself to help pick a property type:
- How much can I spend on a property and how much down payment can I afford?
- What returns am I hoping to achieve?
- How much wear-and-tear am I willing to tolerate from tenants?
- Am I going to manage this property myself?
- Am I worried about property values declining over time?
- How much tenant turnover am I willing to accept?
Each type of property investment will have different implications for investors. Commercial property, for example, is often more expensive and may require higher down payments. However, tenant turnover is usually lower, property values are often more stable, and tenants typically cause less wear-and-tear.
Residential rentals, on the other hand, are typically more affordable and produce higher returns. But, tenant turnover is higher, as is wear-and-tear, and unexpected vacancies can eat into your returns if you aren’t careful.
If you’re serious about investing and plan to use financing to acquire your property, the best thing for you to do before even starting to look for properties is to contact a lender and start working to get pre-qualified for financing.
This will allow you to build a relationship with a lender so you can get approved for financing faster when you pick a property. It will also help you get valuable feedback when the lender reviews your finances and tells you how much property they think you can afford.
Last, but certainly not least, getting pre-qualified can be a big benefit when it comes to negotiating a purchase agreement for an investment property. For a seller, knowing that you have already spoken to a lender and are pre-qualified for financing will reassure them that you have good credit and will probably be able to close.
Sellers hate when deals fall apart because buyers can’t qualify for financing, because they have to take their property off the market for weeks while the buyer tries to work things out with a lender. Knowing that you’ve already taken initial steps shows the seller that you’re serious and that you are a more qualified buyer than someone who doesn’t have a pre-qual letter.
Decide where you want to look
Now that you’ve started working with a lender and are armed with your pre-qual letter, it’s time to decide where you want to own property.
If you want to invest in retail property, don’t look out in the boonies. Instead, focus on commercial centers or well-populated suburbs. If you want to buy a commercial property like an office condo, try to focus where there are clusters of similar spaces.
If you want to buy residential rental properties, you’ll need to drill down a little deeper. To figure out where to look for properties, you’ll need to focus on areas that have the types of tenants you want.
For example, if you like the idea of renting to students or teachers, you should try to focus your search around universities. If you want nurses as tenants or doctors in residency, look for residential areas near hospitals.
Each type of tenant comes with its own advantages and headaches, and each area is going to draw certain types of tenants. Deciding where to look is basically like deciding who you want as a tenant, so be sure you think carefully when deciding where you want to invest.
Look for properties
One of the first places to start looking for potential investment properties is the Multiple Listing Service (MLS). MLS aggregates data from almost all registered real estate agencies and will typically include almost all residential listings in a particular area. While a direct subscription to MLS does cost money, sites like Zillow and MyRental pull data directly from MLS to help you search.
[As a side note, if you’re thinking about investing in residential rental properties, it’s probably a good idea to get set up with a site like MyRental or Zillow Rental Manager. These sites can not only help you find potential properties but also manage those properties, including marketing to tenants.]
While MLS can be super helpful if you want to buy a house for investment purposes, the service doesn’t include a lot of commercial properties. If you’re trying to focus on those types of properties, you’ll need to use a separate service like CoStar or Loopnet.
Using a Realtor
Personally, whenever I look for properties, I end up using a realtor. I have experience with residential and commercial properties, developments, redevelopments, and all types of financing structure, but what I don’t have is deep knowledge of every area where I look for a property.
Sure, I can pick out the big points—there’s the university, there’s a hospital over there, local schools are good (or not). But my knowledge of factors that matter to me is very different from knowledge of the factors that will impact a potential deal—things that a local realtor should know all about.
Using a local realtor should give you much more context about a seller, the history of a property and the surrounding area, maybe even local goings-on that might indicate whether you’re investing in the right property at the right time.
Some realtors also maintain what are called “pocket listings”—properties that aren’t currently on the market but whose owners are open to selling. Realtors who can help source off-market deals can be immensely valuable for investors.
If you decide to use a realtor to help you find an investment property, be sure to inform them that you’re buying to rent. This will help them find the best deals to meet your investment objectives rather than your personal tastes.
Also be aware of your realtor’s fee structure upfront BEFORE you engage them. When you’re buying investment property (especially commercial property) it’s not uncommon for buyers to be responsible for paying their own agent a premium when they close on a property—2%-5% of the final purchase price is typical.
If you don’t know upfront that these fees will be built into your deal, they can be shocking later on—especially because most lenders won’t let you finance them. You’ll need to pay and buyer’s rep fees out-of-pocket at closing.
And don’t think you’ll be able to work around it, either. You won’t be the first person to try. But most realtors will track properties that they show you for months after you view them. If they see the properties sell and find out you were the buyer, you could be on the hook for fees.
DIY Deal Sourcing
While lots of people rely on real estate agents to help them find and negotiate deals on investment properties, you don’t have to use one. The right agent can help you save time and money—many of the good ones can not only help you find properties, but also help you negotiate good deals and find the right lender as well.
However, there are plenty of people who are able to find and buy investment properties without them.
If you aren’t sure you know an agent that specializes in the right area or the right type of property, or even if you just want to try to save some money by skipping commissions, you can try to find your own deals. If you find that you have trouble, you can always decide to work with a licensed realtor later.
Run the numbers
OK—so this step is super dry, but super necessary. When you start searching for properties, you’ll need a way to compare them so you can tell whether you’ve found a good deal, an OK deal, or a terrible deal. To make this easy, it’s best to come up with a system you can use for analyzing their profitability.
This will help you analyze different types of properties with different purchase prices.
One of the best ways to do this is by using a standard worksheet or spreadsheet. You’ll need to make sure that you consider outlays including purchase price, holding costs, expected maintenance, as well as anticipated income.
Plenty of people pay loads of money to expensive schools to get degrees in this kind of thing. And, if you want to do big-money deals professionally, that may be something you want to do down the line, but it certainly isn’t necessary just to be able to analyze a one-off residential property.
If you want to analyze the profitability of your deals quickly and easily, let Google be your friend. You can find resources that other people have developed and shared. Download their templates and use that as your baseline.
As you work through these calculations, be realistic. It’s easy to lose yourself in the numbers and think about how much money you can make if you can find a tenant that will pay you $X in monthly rent, but that kind of thinking isn’t productive if the market will only support a fraction of that in rental income.
If you need help finding tools to help analyze deals, be sure to check out our investment property calculator worksheet in our ultimate guide to investing in real estate.
Write an offer
OK, so you’ve thought about what type of property you want to own and where. You’ve hopefully gotten pre-qualified with a lender and started searching for actual investment properties, analyzing them as you go to determine their relative profitability.
Once you think you’ve found a good investment opportunity and are ready to buy, you have to get the property under contract.
This means negotiating a purchase contract that both you and the seller agree to.
What you need to do (or have your real estate agent do) is draft a purchase agreement and submit your offer to the seller. You’ll need to include details like the price you’re willing to pay for the property, how quickly you’re willing to close, what deposit you’re willing to put down and under what terms, and any contingencies you want to let you back out of the deal.
If you aren’t working with a realtor or are buying an off-market property, you may need to draft your offer by using an online template that works for your area. These documents are often state-specific, but you can often find them available through legal websites like LegalZoom.
When you draft a purchase agreement for a potential investment property, don’t expect that the seller will accept your offer as it’s written. There is almost always some negotiation as part of these deals, so expect to have some back-and-forth on purchase price, closing period, contingencies, and other factors.
This also means that, when you draft your opening offer, you should try to leave yourself some room to negotiate and still come away with an acceptable deal.
Apply for financing
This may seem backwards, but there’s a reason for waiting on this.
When lenders process loan applications, they’re deal-specific. This means that before you can get formal approval on an investment property loan, the lender will need to know what property you’re buying and at what price.
Lenders also have a limited window for loans, once approved, to close before borrowers must reapply.
Plus, lenders will only consider borrower-specific credit information (like your credit score) for a certain period of time before they have to pull another credit report. And each time a lender pulls your credit, that counts as an inquiry that goes on your credit report and actually lowers your score, which can lower your odds of being approved and/or increase your rate if you keep having to reapply.
Now, formal loan approval will actually be contingent on the next step in the process (doing your due diligence), but now is the time to choose the right loan product for the deal you’re pursuing and start the application process.
Types of Investment Property Loans
|Loan Type||How It’s Used|
|Residential rental property loan||Almost like a conventional mortgage, residential rental loans have
fairly normal down payment and interest rate requirements
|Commercial property loan||Commercial property loans typically require slightly larger down payments (25% or more)
and slightly higher rates. Loans may also only last 5, 7, or 10 years
|Fix-and-flip loan||Only for use if you’re buying properties to fix and sell within 6 – 12 months
and don’t have a line of credit or other financing you can use
|Multi-family loan||Federally-insured loan programs designed for landlords buying
properties with 5 or more residential units
|Hard money loan||Very expensive and only last for a year or so, but underwriting is easy and you can close fast|
If you’re interested in a particular type of loan, be sure you ask about it when contacting potential lenders. This will also ensure that the property you’re buying fits the requirements for the loan you want (remember the owner-occupied note from earlier?).
Do your due diligence
After you have a property under contract and have started an application with a lender, there are a number of other things that you have to do before you can close.
Most lenders will require you to have the property inspected and appraised. You’ll also need title work, which may require additional inspections or a survey.
Even if your lender doesn’t require these steps—or if you’re paying cash or using seller financing—you should still plan to complete these steps.
Inspections, appraisals, surveys, and title reviews are all designed to ensure that you know exactly what you’re buying, and that you’re getting what you pay for. If a property has had previous problems with mold or termites, those items should be uncovered in an inspection. If there has been faulty work in electrical or sewage systems, those should also become apparent.
In extreme cases, title work has even discovered sellers who didn’t actually own the property they were trying to sell. Imagine being a buyer who didn’t have proper title reports pulled and wound up paying a seller for property, only to find out that they weren’t even the owners!
I actually had this happen when working with a group on a commercial deal in Maryland. We were trying to buy a building that had once been a string of three downtown storefronts before being combined sometime in the 1970s or ‘80s. What we didn’t know was that there had once been an alley between two of the buildings, and that alley had been deeded over to the city where the property was located.
Before we could move forward with the deal, the sellers actually had to have their city council call a special meeting just to deed a three foot by 25 foot strip of land that ran through the middle of the seller’s already-constructed building. It’s still a mystery to me how the sellers (a group of attorneys) ever completed their renovation without noticing the problem.
These steps are also designed to reassure your lender that you’re making a sound investment. If you fail to pay back your loan, your lender will have to try to recover their money by selling your property, so having things like inspections and appraisals should serve to reassure them that they won’t be left with worthless collateral.
Working through the appraisal and inspection process can seem daunting and stressful, but try not to be overwhelmed. All of the people you enlist to help you throughout this process—your realtor, attorney or title agent, inspector, appraiser, surveyors, etc.—are all there to help ensure you’re getting what you’re paying for.
Address any concerns with seller
Whenever you have a property inspected or appraised, it’s very uncommon to get perfectly clean reports. Inspectors almost always find something with a property that’s not quite right. Appraisals come back low because of a lack of supporting comparable sales in the area. Or title reports unearth some small problems.
Whatever your reports from inspectors or appraisers uncover, you will need to decide how serious these issues are and whether or how to address them with the seller.
If you aren’t sure whether an issue is serious, your real estate agent can be an excellent source of guidance for how pressing these issues are and how best to approach them.
When you bring issues raised in due diligence to a seller, there are a number of ways to address them.
- Some sellers are hard-headed and refuse to do anything. They won’t repair/resolve any issues raised in due diligence, and think that you should’ve taken them into account when making your offer. I had a friend who was buying a house and the appraisal came back low, but the seller flat-out didn’t care. My friend had to decide whether still wanted to move forward and ended up having to come up with thousands of extra dollars for his down payment so he could close.
- Sellers may be willing to repair or resolve issues themselves before closing. This ensures that they deliver to you the property you thought you were buying. And they may think they can get issues resolved fairly inexpensively. When I purchased my most recent commercial property, the seller already knew there was some water damage from a roof leak. Before we even had our inspection, they’d already had a large section of the roof completely replaced.
- Most sellers prefer not to hassle with repairing things themselves, but are willing to adjust the price you pay for the property to account for anticipated repairs. Sellers are usually understanding about these issues—especially when the issues in question are things that you’re going to need to fix after you buy the property. Note: This doesn’t typically hold for title issues. Those will need to be resolved upfront before the seller can convey clean title to you. No lender will let you close on a property with unresolved title issues.
Whenever things come up in due diligence, they’re usually resolved in one of these three ways—or a combination of the three. Issues are typically handled one at a time. If you can’t find an agreeable solution, you may have to terminate your purchase contract.
The same thing is true of appraisals as for inspections. If you get an appraisal report that estimates the value of your property to be lower than the purchase price listed in your contract, you can raise this with the seller just like any other item that comes up in an inspection, and it will be up to the seller to respond.
Close (or don’t)
As you work through the due diligence part of this process, you may find that the seller wants to fight you on every little detail. Or, they may be perfectly reasonable and willing to renegotiate the purchase price to help address any issues that are raised.
If issues do come up and the seller isn’t willing to budge, you’ll likely need to come up with more cash for a down payment to satisfy your lender. Or you can decide not to move forward with the purchase. Depending on the terms of your deal, this may mean giving up any deposits you put down upfront. This is why it’s important to negotiate your purchase agreement carefully.
If no issues come up, you’re able to handle any problems with the seller, or you decide to move forward regardless, you’ll need to schedule a closing for your property. This can only happen after formal loan approval and will need to include your lender, title agent, and/or real estate agent.
People often don’t recognize it, but there are actually a number of different things that happen at a real estate closing, especially when it involves financing.
Whenever you have a real estate closing, you’re typically going through two different closings at the same time. The first closing is on the real estate—the seller is conveying the title of the property to you and you’re actually becoming the owner.
The second thing that’s usually happening at a closing (IF you’re using financing) is that you’re closing on your loan. Most investment property loans are collateralized by the property being purchased, so a lender typically won’t actually release funds from the loan (including to pay the seller) until you own the property.
However, for most buyers and sellers this all looks like one seamless process, with your lender, attorney, or title agent coordinating everything behind the scenes. They’re holding funds or title in escrow to make sure funds aren’t released until title is conveyed. They also usually take care of recording appropriate documents with the local county recorder. This will update local property records to show that you own the property you’re buying and that your lender (if you have one) holds a mortgage against that property.
All that sounds like a lot, right?
It is. But, once you’ve worked through this process step by step, you will now own your investment property—Congratulations!
Rest assured, there’s plenty to do after finishing this process. From marketing your property to finding and vetting potential tenants, even potentially staging your property to attract the right tenant. You’ll need to get set up for bookkeeping, find a handyman or a property manager. There’s always plenty to do when you’re buying or managing investment property.
But, don’t despair. Once you’ve gone through the process of buying your property, you should be able to handle anything else that comes your way. And you’ll be well on your way to building wealth and income to help you on your way to financial independence.
Originally posted at https://thinksaveretire.com/how-to-buy-an-investment-property/