Purchasing an investment property (especially if it’s your first) is a big step. By investment property, we mean purchasing real estate property with the hope that it will generate a return through rental income and appreciation. But before you buy investment property, you need to know some of the basics.
Here are some things to consider and the steps you’ll need to take when purchasing an investment property.
Should You Buy Investment Property?
Is an investment property the right move for you? Before you start looking for properties, there are other ways to invest in real estate and it’s important to consider all of your options. When you buy a property outright, as opposed to passively investing through crowdfunding or a real estate investment trust (REIT), there are several things to think about first:
- Time commitment: Direct ownership can be time-consuming, even if you hire a property manager.
- Capital requirement: There are hefty upfront costs when financing a property.
- Liquidity: Property can take months to sell at fair market value, making direct ownership of real estate one of the least liquid investments.
- Unpredictable income: Although you might be able to generate income, there’s no guarantee it will be steady and predictable.
Decide What and Where You Want to Buy
Real estate markets are local and there are some great markets across the U.S. — and some not-so-great ones. Location determines the desirability of the property, your rental strategy, profitability, and the rate of appreciation. Picking the wrong location could be detrimental to your investment.
And what about the type of property you want to buy? Do you want a single-family home or a multi-family apartment building? What about commercial properties? With so many variables, it’s important that investors do a little research first before buying an investment property.
If you’re not planning to buy investment property with cash, you’ll need to secure financing.
- Conventional mortgage: For a conventional mortgage, lenders typically consider investment properties to be higher risk and most require at least a 15% down payment for an investment property, but the lender may require 30%. Lenders will look at the investor’s personal income and debts.
- Hard money: This is another option for investors looking to quickly finance an investment. However, there are higher interest rates with shorter terms.
- Owner financing: There may be an option in which the seller finances the purchase directly with the buyer.
- Home equity: Investors can borrow against the equity in their home to finance an investment property.
- Commercial investment: There are lenders who specialize in making loans to investors. Commercial lenders base their decisions on the investor’s creditworthiness and whether the property can produce sufficient cash flow to cover loan payments.
Calculate Potential Cash Flow
Investors need to understand the importance of determining cash flow when buying an investment property. If costs of ownership outweigh the rental income it brings, it can quickly become a problem. This is why investors need to understand the potential cash flow of a property before making an investment.
Investors tend to look at the property’s projected net operating income (NOI) for the next 12 months following property acquisition. What about depreciation, mortgage payments (interest and principal), property taxes, and capital expenditures? With a good estimate, investors can determine the property’s worth, the amount that can be borrowed, the equity required, and then potential cash flow.
Is it a Good Investment?
Assess your financial stability, your return on investment (ROI), and the time required to manage a property for each individual location. You also need to think about the housing market, taxes, and if you should hire a property management company. Educating yourself as much as possible will help put you in the best position before buying an investment property.