If you are like me, you may have thought that owning more than one rental property takes a lot of time and hard work. My thoughts were that you bought your primary residence and eventually save up enough money over the years to be able to afford another home. Once you buy the second house, you then rent out the first house and save the rent money until you are able to afford a third house. And then when you are ready to retire, you may have a rental portfolio of two or three homes. While there is nothing wrong with doing it this way, there are also other ways that you can speed up this timeline. Below is a brief introduction into a couple of ways you can go about buying your first rental property.
How can I afford a rental property
Although there have been plenty of news stories over the past couple of years about investors using all cash to buy properties, this is not the only way to do so. Most Americans do not have hundreds of thousands of dollars sitting in their bank account, so another way that you can start buying your first rental property is by using leverage. Most of the time, this leverage will come in the form of obtaining a bank loan. In the current lending environment, your average bank will lend up to 80% of the purchase price for a rental property, meaning that you will have to come up with the remaining 20%. While a 20% down payment is nothing to sneeze at considering prices in Ventura County and the rest of the state, that is still a lot more attainable than having to come up with 100% of the purchase price yourself. And even if you don’t have the 20% sitting in your bank, there are other options that you can find, such as using a home equity line of credit (HELOC).
What are the risks of leverage
Any time you use leverage to buy a rental property, you must always be aware of the risks associated with doing so. The more money that you borrow from a bank, the higher your monthly payments to the bank will be. So if for whatever reason you are unable to rent out your property, you will still be required to pay the bank your mortgage for the month. Plus, anytime a tenant moves out, it will usually take at least a couple of weeks to clean/repair the house as necessary and get a new renter in there. In areas with high tenant turnover, these vacancies can take a lot out of your bottom line. If you don’t have adequate reserves (discussed more below) to cover these vacancy periods, you may find yourself unable to meet your obligation to pay the mortgage on a monthly basis. Besides the monthly payments, the more money you borrow to purchase a property, the more at risk you are of being under water if housing prices decrease.
How to minimize the risk
One of the first ways to minimize your risk when investing in a rental property is by doing your homework and understanding what you are getting into. You need to understand the neighborhood that you will be investing in as well as the numbers behind your investment. In a future blog post, we will share some of the numbers we look at when analyzing a rental property, but you have to take into account more than just your mortgage payment and how much rent you’ll be collecting. As discussed above, you need to account for vacancies, as well as taxes, repair costs, property management, etc. Once you understand these numbers, you must also consider the house and the neighborhood that it is in. Just because you find what might be a good deal on paper, the numbers won’t mean much if you can’t keep the house rented or if the only tenants willing to live in that neighborhood are ones that will trash your home.
Any property with 4 units or less is considered residential and you will find that most traditional banks will loan to you for purchasing these properties. Anything above 4 units is considered a commercial property, and the lending standards for commercial are different than with residential. They key here is that if you find a property with 4 units or less, and you live in one of the units, this property can be considered your primary residence and you can obtain a loan as such. So for example, if you were able to find a duplex or triplex in Ventura, you could live in one unit and rent out the other two units. This could allow you to apply for a FHA loan and put as little as 3.5% down. Of course you would have to meet the restrictions of obtaining that FHA loan, such as living in the unit for at least one year, but this is one way that more and more people are getting into owning their first rental property. Then after an appropriate amount of time, you could move and rent out the unit you were living in and find a different primary residence to call your home.
Any time you own a rental property, you should always have enough cash available to cover unexpected expenses. You want to make sure that you are able to afford vacancies and major repairs, among other things, especially if you are using bank financing and have a debt to pay each month. How much you want in reserves is up to debate and will depend on your risk tolerance. From what I have seen, most experts tend to recommend that you have between six months and a year’s worth of expenses saved up in reserves. How much you decide to have in reserves is ultimately up to you, but if nothing else, you should have enough saved up where you are able to sleep comfortably at night when thinking about your reserves.