In many ways, rental houses are similar to owner-occupied houses that are bought as personal residences. When you buy a rental house, you want to get a desirable property for a fair price, just like with a residence. The difference is that you’re not buying the rental property to live in. You’re buying it to make profit. This not only changes how you look at it, but also changes how you will finance it.
1. Research rent levels in your desired neighborhoods to determine what you can charge for a rental property. As you do this rent survey, also research what services landlords typically include with rental properties and what the cost of those services will be.
2. Source a lender that specializes in investment properties. Most traditional mortgage programs are for owner-occupied homes, so you will usually be ineligible to use them. If you cannot find a bank that will finance your purchase of a rental home, consider using a line of credit or using a private lender.
3. Begin sourcing properties. If you are not planning to buy a property and fix it up, look for properties that have adequate fit and finish and that are neutral. The goal with a rental home isn’t to have a property that you’d love to live in; it’s to have a property that the largest number of potential renters will consider while not having too many expensive features to maintain.
4. Project exactly how much rent you can collect from the property and subtract your mortgage principal and interest, tax and insurance payments from it. If you end up with negative cash flow, the property is definitely unsuitable as a rental, unless you have another strategy, like selling for appreciation, in mind.
5. Subtract your cost of management, a vacancy factor, the cost of any services you offer, and a budget for repairs from the cashflow left over after subtracting your PITI payments. The vacancy factor you select varies based on market conditions, but assuming an 8.33-percent vacancy factor, which is one month per year, is a good starting place. If this yields a negative number but you still feel the house is a good investment, talk to an accountant. The value of the depreciation write off for the house could turn the loss into a small profit. If the number is positive, the property is a good candidate for purchase.
6. Divide your annual net cashflow by the amount of money you plan to invest in the property to calculate your cash-on-cash return, also known as an income capitalization rate, or cap rate for short. Make sure you include your down payment, closing costs and any capital expenditures you make on repairs. Cash-on-cash returns vary depending on the type of house you buy, its location, and the surrounding market conditions, but anywhere from a 3- to 10-percent return is normal for a rental house. Since you hope to be increasing rents yearly, the returns will grow. Additionally, the money that goes to pay down your loan further increases the return that you will realize when you sell the property.
7. Place the property under contract, inspect it and close it. The process of buying and closing a rental house is similar to the one that you use when you purchase a personal residence.