6 Steps for Investing in Rental Property

For investors wanting to diversify their portfolio, rental properties offer a lot of opportunities, but investing them also requires a fair amount of legwork. Beyond simply finding a great property, you have to consider the amount of time you can put into managing it. There are federal and local laws to comply with, and you want to plan for the cost of operating the property in addition to buying it.

It’s a lot to take in. However, by digging into these issues upfront, you can prepare for your new role as a property investor and landlord—and maximize the potential of your investment. Sound appealing? Follow these six steps to invest in residential real estate property:

1. Be Realistic About the Undertaking

The reality of real estate investing is that there’s a lot of work and sometimes stress involved as well. You’ll need to find and keep tenants, and manage the property and any necessary repairs. The payoff is a steady monthly income and hopefully a big return down the road, once you resell. But the work to get there involves both time and money that goes beyond simply purchasing the rental. As an investor, it’s important to consider the full picture of purchasing a rental property before you make the leap. Finally, if you’re interested in diversifying your portfolio via real estate, but don’t want to take on the work of managing a property, there are other ways to invest such as REITs or crowdfunded real estate.

2. Review Your Financial Capabilities and Goals

Experts debate whether investors should borrow money to buy rentals or purchase them outright. If you’re leaning toward financing a property, start by getting pre-approved for a mortgage. The process will give you a better understanding of the top end of your financial commitment and allow you to explore how you want to finance the purchase.

As you investigate financing, don't forget about the other expected costs of owning a rental. Make sure that your financial analysis includes property management fees, property maintenance expenses, and the cost of expected vacancies. Then build a financial model that includes the initial down payment for the property, your anticipated monthly obligation to the mortgage and operating costs compared to the expected income. You’ll come away with a solid understanding of how a rental may impact your finances and how much you can afford to invest.

3. Learn About Landlord and Tenant Laws

Becoming a landlord means you need to comply with a host of legal obligations or face serious consequences. There are federal regulations, as well as state and local laws to follow when it comes to renting property to tenants. For example, federal law requires that landlords make reasonable accommodations for tenants with disabilities, and the Fair Housing Act prohibits discrimination against people who have physical or mental impairments. More locally, cities such as Portland, Ore. have capped how much landlords can increase rent each year. Landlords who violate the rules are required to reimburse their tenants for the rent plus any related damages. These are just a few legal issues to keep in mind; more generally, there is a range of processes you need to follow to legally rent a home to a tenant as well as to evict someone. And being aware of these requirements is critical.

4. Find a Property That Meets Your Objectives

Once you’re on board with becoming a landlord and you’ve determined how much you can invest, then the fun of finding a property begins. Real estate investing is equal parts art and science, and there are multiple strategies for determining what type of home you want to buy and where. For example, some investors focus on multi-family units because they provide more cash flow (but they’re also more work because there are multiple tenants). Others look for homes in up-and-coming neighbors or homes that they can refurbish, rent or quickly flip.

Just like you did for your financial analysis, you’ll want to think about what type of property works for your investment goals. Consider:

• Do you want a property that’s a fixer-upper?
• Are you planning on doing the work or hiring it out?
• Would you pay more for a home in a nicer area, assuming you could charge more rent?
• Does your desired price point limit where you can buy geographically?

5. Expect the Unexpected

Much like in regular life, in property investment, a surprise expense can quickly derail your financial plan. With rental homes, however, it’s even more important to respond to repair requests and upgrade needs—otherwise, you may find yourself without tenants or, worse, in a battle with your renters. A common rule of thumb for landlords is to dedicate 50% of their rental income to operating expenses, which includes unexpected repairs as well as regular maintenance, taxes, and property management services. Maintain a reserve of at least 5% of your annual rental income specifically for emergencies. That's a smart move—what's even smarter: anticipating that you may need to spend even more on repairs and general maintenance and saving accordingly.

6. Keep Tabs on the ROI

Investing in real-estate generates some immediate cash flow and will hopefully allow you to make money on the property over time. The key to both is paying close attention to the ROI of the property, and making adjustments as necessary. Whether you financed the property or paid cash, calculate the ROI at least annually—if not more often. That way if your expenses are getting out of control, you’ll be able to see it quickly and take action to fix them, whether that’s increasing the rent, taking on the property management yourself, or spreading out improvements over a longer period of time.

By taking a methodical approach to becoming a real estate investor, you'll come into this next exciting stage prepared financially and mentally for your role as a landlord. You'll optimize your investment, and reduce the stress of managing property in the meantime.