Shortly after buying their first rental property, many real estate investors get the itch to buy more.
They’ve read about how a good income-producing property generates monthly cash flow and gradual appreciation in market value. But reality really hits home as they watch their bank account balance grow every month from the owner deposits the property management company makes.
Why Own More Than One Rental Property?
It’s true that steady passive income is one of the biggest benefits investors receive from owning rental real estate. However, there are also several strategic reasons for owning more than one rental property.
Build a real estate portfolio
Investing in single-family rental property is perfect when you’re a passive income investor using the technique of “lather, rinse, and repeat.”
There’s always a learning curve when you buy your first property. But once you find a system that works for you, following the same steps makes each deal you do easier and easier.
As you grow your portfolio, you may also find that after just a few short years there’s enough equity in your first property to do a cash-out refinance and use that cash to buy another rental house. Eventually, the monthly income and equity appreciation from each property in your portfolio acts as a funding source for cash so that you won’t have to contribute extra money to make your next down payment.
Risk diversification with rental property mix
Buying multiple rental properties is also a technique that investors use to mitigate risk by changing the rental property mix. Real estate is often thought of as one big asset class, but the fact is that there are about 350 cities in the U.S. with populations of more than 100,000 people.
As you might imagine, not all of these real estate markets perform the same way, and some are better for rental property investors than others. By owning single-family rental houses in different high-performing markets across the country, you minimize the downside risk to your portfolio should one city lose a major employer or become over built.
Diversify investments in your portfolio
Owning one rental property is sort of like owning the stock of only one company. If the price of the stock goes down by 30%, so has the value of your entire stock portfolio.
That’s why most people who own stocks and bonds invest in an ETF or mutual fund, and why real estate investors work hard to own more than one rental property.
Successful real estate investors know that despite their best efforts, there will be times when a property is vacant longer than expected or a major repair needs to be made. By owning several rental properties, the short-term reduction in cash flow is spread across all of your holdings, helping to keep your portfolio value high.
How to Evaluate Each Rental Property
Long-distance real estate investing is a technique that investors use to buy multiple rental properties and diversify risk. But buying property in a market you’re not familiar with can be difficult unless you know where to look, and what to look for.
Here are some of the best places to look for good single-family rental houses and the key financial metrics for evaluating each rental property you find:
- MLS along with a licensed real estate agent who understands investors
- Zillow and Realtor.com, public online databases that have direct data feeds from the hundreds of MLSs throughout the U.S.
- Roofstock, an investor-focused online marketplace for finding single-family rental houses and larger portfolios of rental property already rented to tenants
The three most common metrics used to evaluate rental property are cap rate, cash-on-cash return, and ROI (return on investment):
- Cap rate: Uses NOI (net income, excluding the mortgage payment) and market value of the property to estimate your expected rate of return. Cap rate = NOI / Market value.
- Cash-on-cash return: Calculates the rate of return by comparing the cash income earned to the cash invested in a rental property. Cash-on-cash return = Annual pre-tax cash flow / Total cash invested.
- ROI (return on investment): Measures percentage of investment profit compared to the cost of the investment. ROI = (Net profit / Total investment cost) x 100.
In addition to cap rate, cash-on-cash, and ROI, other financial metrics real estate investors use to evaluate rental property include cash flow, gross yield, annual return, and total return.
If you’re looking for an easy way to crunch all of these numbers, this simple spreadsheet by Roofstock can help. You can use it to forecast the potential return of a property. Simply enter some information to view projected key return on investment (ROI) metrics, including cash flow, cash-on-cash return, net operating income, and cap rate.
Tips for Financing Multiple Rental Properties
Financing your first few rental properties is relatively easy. But as you buy more property, getting a mortgage becomes more difficult – until you learn how to be creative and think outside of the box.
First 4 properties
- Conventional financing with a long-term loan at a low interest rate
- Good credit score and conservative LTV (loan-to-value) of 80% or less
- Proof of personal income, assets, and debts
- Reports showing the financial performance of your existing rental properties
5 to 10 properties
- Fannie Mae 5-10 Financed Properties program
- 25% minimum down payment for each single-family rental
- Six months of PITI (principal, interest, taxes, insurance) in reserve for each property financed
- On time payments for all existing mortgages for the last 12 consecutive months
10 properties or more
- Portfolio lenders can be more creative with loan terms and conditions because they keep the mortgage in-house and focus on the rental property performance
- Blanket loans are used to finance multiple rental properties under one single mortgage, so instead of having multiple small loans you would have one large blanket mortgage
Creative ways to finance
- One-participant 401(k) for small business owners with “checkbook control” lets you act as your own trustee and custodian to direct where you invest
- Self-directed IRA allows you to buy and sell rental real estate within your retirement account
- Cash-out refinance lets your turn the accrued equity in existing properties into cash to use as a down payment to buy more rental property
- HELOC (home equity line of credit) creates a line of credit against the existing equity in your property so that you have access to the fund when and if you need them
- 1031 exchange is used to relinquish one investment property and acquire another, while deferring payment on any capital gain tax owned, leaving you with more money to invest
Why Experienced Investors Use LLCs
A Limited Liability Company (LLC) is a legal structure real estate investors use to protect their other business and personal assets. As you buy multiple rental properties, it’s a good idea to put each property in its own LLC.
There are three main reasons to use an LLC:
- Protect your personal and other business assets from a lawsuit. Without an LLC, a guest of one of your tenants who has an accident could sue you for damages. If the claimant wins, he could go after your personal residence and savings, and all of the other rental property and business assets you own.
- Keep business expenses separate from personal expenses. Having an LLC for each rental property you own makes it much easier to assign income and expenses to the right property and avoid the risk of intermingling personal expenses with business expenses.
- Having an LLC may reduce your tax liability because income or losses are passed through to each shareholder rather than at the corporate level.
Important Things to Consider Before Buying Multiple Rentals
While there are similarities to buying one rental property and multiple rentals, there are some big differences as well. Here are some of the most important things to consider before you decide to buy multiple rental properties:
Know where you want to end up before you begin
Some investors buy multiple rentals properties so they can retire early, others want to build a legacy investment they can pass on to their children. Knowing what your personal endgame is key to setting your goals and developing an investment plan.
Use leverage to your advantage
Conservatively using leverage is a key way that real estate investors strike a balance between risk and reward. By using an LTV of 75% you have enough equity in the house should market values begin a cyclical decline. And, with a larger down payment, your mortgage will be lower and your cash flow greater, creating an additional income cushion that helps reduce risk.
Think of your portfolio as a cash generating machine
After you’ve added several rental properties to your portfolio it won't be long before you can begin leveraging those assets to buy more property.
With strong and steady cash flow from each property combined with market value appreciation, you’ll be able to use cash-out refinancing to create organic capital to invest in additional income producing real estate.
Use a professional property manager
At the beginning of this article we explained how investors diversify risk by owning rental property in different markets across the U.S. When you invest in real estate long-distance, it’s important to have a trusted property manager in each market that you operate in.
They understand the unique characteristics of the real estate market, know the local landlord-tenant policies, and can help you identify trends and opportunities before they become mainstream.
There’s a learning curve when you begin buying multiple rental properties. But with the right strategies, there isn’t any reason why you can’t begin adding good cash flowing properties to your portfolio.
In fact, once you have a system in place, you’ll find that the benefits that rental real estate provides are exponentially increased with each property you invest in.
- Diversification is one of the main reasons investors buy multiple rentals.
- Key metrics used to analyze rental property include cap rate, cash-on-cash return, and ROI.
- Creative ways to finance multiple rental properties include the FNMA 5-10 Financed Properties Program, portfolio loan, and a self-directed IRA.
- Over time, your real estate portfolio could generate enough cash to create organic capital to buy more rental property.