Investing in rental property is a strategy many people use to generate rental income and build wealth. However, while owning real estate can potentially be profitable, it’s important to do things correctly right from that start.
Here are 10 things that every beginning real estate investor needs to know before starting a rental property business.
- Learning the real estate business and choosing an investing strategy are the first steps to starting a rental property business.
- Active real estate investors work full-time in the business, while passive investors focus on recurring income and long-term appreciation.
- Many investors choose single-family rental homes because rents are growing and property prices are soaring.
10 important things to know before starting a rental property business
Some investors may already have the experience or connections to skip one or two of the following steps.
For example, people who work in the lending business often become real estate investors because they understand how financing works. Other investors may be lucky enough to have a mentor who shows them the ropes.
With that in mind, here’s a list of 10 key things to do and know before starting a rental property business.
1. Invest in education
In most instances, it’s not necessary to have a real estate license to start a rental property business unless an investor plans on buying, selling, or managing properties for other people.
Instead, many investors add an investor-friendly real estate agent to their team to bird dog for off-market real estate deals.
There’s plenty of free information available to start learning about the rental property business, including real estate blogs and local investment groups.
Investors who are ready to take their game to the next levels invest in training programs like the Roofstock Academy to learn how to build income with rental property.
By understanding how to analyze deals based on facts instead of emotion, and how to find investment properties with strong yield where prices are more affordable, an investor starting a rental property business can gain a competitive edge.
2. Choose an investing strategy
There are two main types of rental property investing strategies: active and passive.
Active real estate investing means working hands-on in the business, such as fixing-and-flipping homes or wholesaling real estate.
Although it requires a real estate license in many states, one of the advantages of wholesaling real estate is that it doesn’t require a lot of money. In fact, the most successful wholesalers put a property under contract with just a small earnest money deposit, then assign the purchase contract to another investor to close on the deal in exchange for a wholesaling fee.
An active investing strategy may be a good match for people who want to work in real estate full time, and for those who are willing to accept a higher level of risk by wholesaling or flipping homes.
There’s also a more passive approach to real estate investing that buy-and-hold investors follow. After doing initial leg work, such as researching markets for rental property and negotiating a deal, they turn the day-to-day details over to a local property manager.
Passive real estate investors purchase rental property to build a rental income stream, profit from the potential appreciation in property values over the long-term, and enjoy the tax benefits that come with owning a rental property.
3. Pick a rental property type
Two of the most common residential real estate niches are single-family rental (SFR) homes and small multifamily buildings with two to four rental units.
Both types of rental property are relatively easy to find in every real estate market, financing is usually readily available, and the demand for good residential rental property is generally strong.
Currently, the demand for single-family rental homes from both tenants and investors is strong.
As the Q2 Single-Family Rental Investment Trends Report from Arbor Realty Trustreveals, record demand for SFRs is sending rents and home values soaring. So far this year, occupancy rates are over 95% (the highest they’ve been since 1994), pushing vacant-to-occupied rent growth to a record high of 12.7%.
4. Develop a business plan
After getting educated, and choosing an investing strategy and property type, the next thing to do before starting a rental property business is to develop a business plan. The basic steps to create a rental property business plan are:
- Put into writing the primary goals of the rental property business, such as the number of properties that will be purchased in each of the next five to ten years, and how much income will be generated at both the property and portfolio level.
- Develop a strategic plan with small, specific, actionable steps such as analyzing five potential investments each week, purchasing one SFR per year, and interviewing the top property managers in rental markets across the country.
- Create a financial plan that includes funding sources for a down payment (such money saved or a self-directed IRA), accounting for operating expenses such as property taxes, maintenance and repairs, and owner expenses such as travel expenses and continuing education.
5. Create a business entity
Many rental property investors own property under their own name as a sole proprietor. While owning a rental property as an individual may be the path of least resistance, an investor’s business and personal assets may be at risk if things don’t go according to plan or someone decides to sue.
That’s why many investors create an S-Corporation or limited liability company (LLC) as a business entity for a rental property business.
Both types of companies are known as “pass-through” entities, which means that income or losses from the rental property flow through to each member of the S-Corp or LLC.
Holding rental property under a business entity may also provide an additional layer of legal protection, because generally the only assets at risk are those owned under the business.
6. Learn what makes a rental property profitable
There’s a big difference between buying a home to live in and selecting a good rental property. By putting personal preferences aside – such as liking lush landscaping or a brightly colored kitchen – it’s easier to find a good rental property that appeals to a wide range of prospective tenants and is simpler and less expensive to maintain.
Some of the factors and features that can help make a rental property a profitable investment include:
- Being located in an area with strong population growth.
- A steady or growing job market.
- Low property taxes.
- A high renter occupied household percentage, which is an indicator of the demand for good rental housing. For example,renter-occupied households in cities like Orlando and Austin account for 56% or more of the housing units (Census Reporter).
- Available homes for rent is another supply and demand indicator real estate investors monitor.
- Rent growth trends. In some real estate markets, like Las Vegas and Phoenix, rents are up by 20% or more year-over-year (according to Zumper).
- Location and the environment around the home such as future development, amenities like shopping, and where the home is located in the subdivision all have an impact on how good a rental property is.
- Neighborhood rankings, based on location-specific variables such as school district quality and employment rates, can give investors a better understanding of the potential risks and rewards in different neighborhoods.
- Hiring a skilled property management company to handle day-to-day details such as marketing and leasing, rent collection and tenant communication, and repairs can help investors to maintain property value and increase cash flow and gross yield.
7. Understand how financing works
Real estate investors use leverage (or other people’s money) by making a down payment of about 25% to control 100% of the rental property.
Rent payment from the tenant is used to pay for the mortgage and property operating expenses, while an investor profits from any remaining cash flow and appreciation in property value over the long term.
Common options for financing a rental property include:
- Conventional loans
- Conforming loans backed by Fannie Mae and Freddie Mac
- Federal Housing Administration (FHA) loans
- VA Home Loans for servicemembers and surviving spouses
- 203K loans for repairs and rehab
- Hard money loans or private financing
- Portfolio loans and blanket mortgages for investors with multiple rental properties
Interest rates on a rental property loan usually are between ½ percent and one percent higher than the mortgage rate for a primary residence.
There are several things real estate investors can do to help get better rates and terms on a loan for an investment property, including maintaining a good credit score, making a large down payment, and having a personal debt-to-income (DTI) ratio of no more than 43%.
8. Know how to run the numbers
Investing in rental property is all about the numbers. Key metrics that investors use to analyze and monitor the financial performance of rental property include:
Gross rent multiplier (GRM)
GRM is calculated by dividing the property price by the gross rental income and is used by investors to help determine the worth of one property versus another. Generally speaking, the lower the gross rent multiplier is the better the opportunity, although GRM does not factor in operating expenses or vacancy rates.
Net operating income (NOI)
NOI is the money made from a rental property and is calculated by subtracting income from operating expenses, excluding items like the mortgage payment and capital repairs.
Capitalization or cap rate is calculated by dividing NOI by the property price or market value and is a measure of return on investment. In general, the higher the cap rate is the more attractive the investment may be. Because different markets have different average cap rates, capitalization rate is only used to compare similar properties in the same real estate market.
Cash flow is the amount of money remaining at the end of each month after all of the rent has been collected and all of the bills have been paid, including the mortgage and contributions to a CapEx (capital expense) account.
Also known simply as cash-on-cash or CoC, cash-on-cash return measures the amount of pre-tax cash flow received compared to the amount of cash invested. For example, if an investor makes a $25,000 down payment on a rental property and the annual before-tax cash flow is $3,000 the cash-on-cash return is 12%.
Debt service coverage ratio (DSCR)
DSCR is used by lenders and real estate investors to assess if a rental property is generating enough income to pay for the mortgage after the property’s operating expenses have been paid. To calculate the debt service coverage ratio, simply divide the NOI by the annual mortgage payment. Lenders generally look for a DSCR of 1.25 or more when underwriting a rental property loan.
Loan to value (LTV) ratio
LTV measures the amount of leverage on a property and is calculated by dividing the loan amount by the property value. For example, if an investor makes a 25% down payment on a $100,000 property, the loan to value ratio is 75% ($75,000 mortgage amount / $100,000 property value). Lenders typically want an LTV of 75% or less before approving a loan, to make sure that there is enough equity in the property.
9. Research different real estate markets
There’s no rule that says someone has to buy a rental property in the same city where they live. In fact, sometimes attractive returns can be found in smaller cities where the population is growing and housing prices are still relatively affordable.
Although the local MLS and a real estate agent might be good for people buying a home to live in, the Roofstock Marketplace is a go-to source for investors looking for a good turnkey rental property.
At any one time, there are hundreds of single-family homes and small multifamily properties listed for sale, oftentimes already rented to a tenant. Each listing includes valuable information such as photos, financial projections, and due diligence items such as a tenant ledger and a title report.
The entire sales process can be done online, including negotiating with the seller, making an offer, applying for a mortgage, closing escrow, and hiring a preferred local property management company, if desired.
10. Select accounting software
Even with a property manager taking care of the daily property details, real estate investors still monitor the performance of each rental property and the entire rental property portfolio.
Stessa is a free asset management software system designed to help real estate investors automate income and expense tracking, and maximize profits through real-time insights and smart money management.
After signing up for a free Stessa account and entering some basic information, landlords can run informative reports including income statements, net cash flow, and capital expense reports. Important documents, such as lease agreements and vendor receipts, can be organized and stored securely in the cloud, and the Stessa Tax Center helps make tax season a breeze.
Many people start a rental property business to generate rental income and long-term wealth, but it’s important to do things correctly right from the beginning. Although starting a new business is never easy, investing in real estate is something that everyone can do. After spending time learning the business, select an investing strategy, begin researching rental property in some of the best markets from coast to coast.