Originally posted in February 2017
Edited April 2024
Investing in Rental Properties for Beginners
Real estate investing covers a much broader spectrum of investment vehicles than most people realize. This spectrum ranges from the very passive strategy of buying real estate-related stocks on a public exchange, investing in Real Estate Investment Trusts (REITs) or even investing in deals through a real estate crowdfunding platform, to the more active approach of purchasing individual properties directly — either to resell them for profit, or to rent them out for ongoing income.
Contrary to much of the conventional wisdom and many real estate books and courses, investing in rental properties is not a strategy for earning passive income. In fact, it is among the most active and time-consuming forms of real estate investing in which you can engage.
In the sections that follow, we will discuss the basics of investing in rental properties, including an overview of how to find a viable rental property and obtain financing for it, what may be involved in operating and maintaining the property, and the basic pros and cons of such investments. We also describe a real estate investment approach that can serve as a possible alternative should you find that direct investing in rental properties process is not right for you.
If you would like to learn more about investing in rental properties, as well as other real estate investing opportunities, visit the RealtyMogul Knowledge Center.
Income Property Investment — Investing in Rentals
Although there are many ways to directly invest in real estate, for simplification purposes, we can break the investment approaches into two primary categories: investing in a property to potentially resell it quickly for a profit, and investing in a property for the long-term and renting it out.
One potential benefit of investing in a rental is that it has the possibility to provide two types of return. First, it can provide appreciation over the long run, if the property value increases over time and due to improvements made by the owner, and as the owner increases equity in the property by paying down the mortgage.
Second, the owner also has the potential to realize an ongoing return in the form of positive cash-flow on the investment — earned by renting the property out to tenants for monthly payments that exceed the owner’s overall monthly expenses to maintain the property.
If an investor can obtain attractive financing to secure a rental property that produces positive cash-flow in an appreciating market — and if the investor is willing to take on the responsibility of managing the property (or working with a property management company) — then rental property investing can be a viable real estate investment strategy. Of course, just as with any investment, it is important to understand that rental property investing carries the risk of loss and there are no guarantees of a return.
Rental Property Investment Strategy
To determine whether a rental property investment can work for you, you first need to come up with an informed estimate of the return on investment (ROI) that the property is likely to generate.
For many types of investments, you can determine the ROI by calculating a simple formula: gains minus cost, divided by the cost. In the case of a stock investment, for example, if you pay $10,000 for stock in a company and sell your shares later for $12,000, then you’ve realized an ROI of 20%. That’s a net profit of $2,000, divided by the original $10,000 purchase price — giving you a 20% return on your investment.
In reality, the ROI calculation will be more complicated than this, because you will need to factor in expenses such as capital-gains taxes on your stock sale and any broker fees you incurred while buying and selling your shares.
But things get more complicated still when you are attempting to determine the ROI potential in advance of investing in a rental property — because there are so many variables that can affect both the income potential and the expenses of the property.
Determining the possible ROI of an income-producing property will require you to make estimates (based on whatever historical data is available) on market rental rates, vacancy rates of similar properties in the area, ongoing expenses for maintaining and operating the property, and other variables that might change at any time. And bear in mind, as stated previously, rental property investments carry risk of loss just as any other type of investment, and returns can never be guaranteed.
How to Determine a Good Rental Property
There are many criteria you’ll want to consider in your search for a good rental property in which to invest. If you’re looking for a residential rental property — such as a single-family residence or a small apartment complex — you may want to focus your search within neighborhoods with homes appreciating in value, low crime rates, strong employment figures and well-rated schools.
But assuming you have narrowed your search for rental investments to a given area or even to a few specific properties, you should then run some basic calculations to get a better sense of how well those properties might be able to generate income for you.
Your goal, of course, will most likely be to find a rental property that generates positive cash-flow — where the rents and any other income you earn on the property is greater than all expenses, including your mortgage payment, property management fee, property taxes (calculated monthly), repairs, insurance, etc.
Imagine you were to purchase a four-unit apartment complex for $300,000, and you took on a $1,900 mortgage payment (which included escrowed property taxes, paid by the mortgage company). You then hired a property management company for $150 to handle screening tenants and managing repair and maintenance issues. Further assume that ongoing maintenance work like landscaping for the apartment runs you another $200 and that for expenses you are responsible for on the property, such as some of the utilities and property insurance, cost an additional $500. Your total costs, then, come to $2,750 per month.
Finally, assume you can charge $800 per unit and that all four units rent. That gives you a gross income of $3,200 — a net operating income of $450 per month.
Another way to determine whether or not a rental property might be viable for you is to use the simple 1% rule. This guideline allows you to take an estimate of your monthly income on a rental property and divide it by the purchase price — and it argues that if that number is in the 1% range, then you might have a good rental property.
Using our example above, if the purchase price were $300,000 and the estimated monthly income were $3,200 (assuming no vacancies during the year), then that would give you a better-than-1% return, 1.06% in fact.
However, these calculations are always more complicated and require accounting for more variables. In the hypothetical example we’ve been using here, you might also need to build a 5% vacancy into your estimate because that is the standard vacancy rate for similar properties in the area. That would take your annualized income estimate from $38,400 ($3,200 per month times 12 months) down to $36,480 — to reflect a 5% drop in income due to a vacancy. Now your monthly income estimate will be $3,040 — still roughly 1% of your purchase price, and still, therefore, a potentially viable deal. Keep in mind that this is purely a simplified example and potential opportunities can vary from the example provided.
Buying Rental Properties
One of the most challenging aspects of buying rental properties is compiling a complete list of all expected expenses. Failure to take into account even one upfront capital outlay or ongoing expense can lead you to an inaccurate estimate of the cost and income potential of your property.
That list of expenses is long and includes agent/broker commissions for acquiring the property, mortgage fees, cleaning and maintenance, repairs, utilities, insurance, advertising for tenants, mortgage interest, property management, your time and expense traveling to and from the property, taxes and tax-return prep, legal fees, the costs to replace appliances, etc.
It is extremely difficult if not impossible to know in advance all of the expenses your rental property may require. For this reason, as you are calculating a property’s income potential, it is important to gather as much information on the property and similar properties in the area as possible. It is also advisable to err on the conservative side in your calculations — factoring in an additional percentage of expenses for unforeseen costs.
Financing a Rental Property
Financing an income property is typically more difficult than financing a home or other primary residence.
The major distinction is the size required for the down payment. Whereas home buyers with strong credit can find financing opportunities that require just a few percent down on a primary residence, investors typically must put down at least 20%.
There are other financing options available, however, some quite creative. For example, an investor can ask for “seller financing” or “owner financing,” where the owner of the property serves as the bank or mortgage company, and the investor places an amount of money down for the purchase and promises a certain amount monthly — just as they would do with a traditional mortgage company.
Indeed, these transactions in most ways mimic a standard mortgage arrangement, involving agents and an escrow company, and the investor’s credit and good name are just as much on the line for satisfying the mortgage responsibility as they would be if the loan were held by a big bank.
An investor can even raise the needed down payment through other means, such as by taking out a home equity line of credit on their primary residence (or other property), or even through a real estate crowdfunding platform.
Buying a Vacation Rental Property
Another way to invest in rental property is by buying and renting out a residence in a vacation destination.
But as exciting as the idea of owning a vacation rental can be, you need to understand the realities of such an investment — and subject it to the same business calculations you would with any other rental investment.
One challenge to owning a vacation rental is that, because they will likely not be rented 100% of the year — and in many cases only for a few months of the year — your per-night or per-week rental rates will need to be high to keep your investment cash-flow positive for the year. (After all, you can’t take a break from your mortgage payments in the slow season).
Another thing you should consider when deciding whether or not a vacation rental is a smart investment for you are the expenses of owning such properties — and these are often higher than they would be for comparable properties not in vacation hotspots. The cost of advertising your rental unit, for example, will almost certainly be high because it could take slick, elaborate ads to entice prospective vacationers.
Additionally, because your vacation property can be turning over much more frequently than would a standard residential rental, you could also need to spend more money per year on cleaning, replacing broken or missing items, insurance, etc.
For these reasons, vacation rentals can be among the most challenging types of rental properties for investors.
How Can a REIT Help Me Get Started in Investing?
If the thought of searching for the right rental property, trying to calculate your return on investment, and dealing with tenants’ leaky faucets sounds like more than you’re willing to take on — but you’re still interesting in investing in real estate — one alternative might be to invest in a Real Estate Investment Trust or REIT.
With an investment in a REIT, you can enjoy many potential benefits, including the chance to realize a long-term return through appreciation of the properties included in the portfolio and ongoing income typically paid out quarterly.
Additionally, because a REIT is a truly passive investment — real estate and property management professionals find and then manage the day-to-day operations on these deals — such an investment gives you the potential to enjoy both the short- and long-term returns of investing in a rental property without having to do any of the work.
Of course, as an investor, you should carefully consider the risk factors involved in any REIT before purchasing shares. Risk factors include the overall risks of the real estate market as well as the minimal operating history of the REIT, and the ability of the REIT to implement its investment strategy as set forth in its offering circular.