The Ultimate Guide To Purchasing and Financing Investment Properties

Purchasing an investment property can be an ideal strategy for generating income and building your net worth. However, it also comes with risks. Before you jump into owning rental property, understand the different factors involved — your readiness to take on the challenges of owning investment property, financing options, agents and the selection process, to name a few — to help you weigh the pros and cons of investing in real estate.

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To make an informed decision on whether buying an investment property is the right financial move for you, check out these tips for investing in real estate property.

Benefits of Owning Investment Property

The percentage of single-family homes purchased by investors grew to record levels at the end of 2023, even as growth in home values slowed, according to the real estate market research firm CoreLogic. Single-family homes are just one of the property types investors purchase, but that trend highlights real estate’s attractiveness as an investment option.

Investors see three primary benefits of investing in real estate.

Income

An investment property can begin generating income almost immediately if you buy one ready or nearly ready to receive tenants. While managing your own property — collecting rents, managing the relationship with your tenants and performing maintenance and repairs — is an active activity, you can hire those services out to turn the property into a passive income generator.

Appreciation

Real estate is a long-term investment that usually appreciates in value over time. From 1990 to 2023, for example, real estate only lost value during the five years spanning the housing market crash and recovery.

Otherwise, growth has ranged from a low of 1.1% in 1990 to a high of 17.97% in 2021, according to Statista, citing data from the Freddie Mac House Price Index. Data from Macrotrends shows that by contrast, the S&P 500 had negative gains in nine years during that same period.

Tax Benefits

The IRS taxes rental income in the same way it taxes wages from a job or income from self-employment. But you can reduce your taxable income by deducting many of the expenses associated with owning rental property in the same year you pay them. Deductible expenses include:

• Mortgage points and mortgage interest

• Commissions

• Legal, tax and other professional fees

• Maintenance

• Repairs

• Insurance

• Property tax

• Management fees

• Utilities

You can also deduct the cost of purchasing the property by depreciating it over its expected life. And in the event you sell it for considerably more than you paid for it, you can defer capital gains tax through a like-kind exchange. Also called a 1031 exchange, this strategy lets you defer capital gains tax if you purchase a new rental property at the same time you sell your current one in a transaction facilitated by an intermediary.

Key Considerations Before Buying an Investment Property

Unlike a stock investment that you can sell almost immediately if you realize it’s a bad fit for your portfolio, real estate is an illiquid asset that takes time and money to sell. That’s why it’s imperative to understand what you’re getting into before you sign a contract.

Personal Financial Readiness

Financial considerations should include the following:

• Your ability to qualify for financing

• Costs of preparing the property to rent

• Securing tenants

• Maintaining and repairing the property after tenants move in

Whereas you can take out a conventional loan with 5% down to buy a home you plan to live in, you’ll likely need 15% to 25% down for an investment property, depending on the property type. You’ll also pay at least 0.50%, and perhaps closer to 2%, more in interest, depending on the size of your down payment, compared to a residential property, according to Fairway Independent Mortgage Corp. You’ll need significant cash reserves and strong credit to qualify.

While your property will generate cash flow as soon as a tenant begins paying rent, it won’t generate positive cash flow unless that rent covers all of your expenses. In the meantime, you’ll have to pay any shortfall out of pocket in addition to keeping enough reserves on hand to cover expenses during vacancies and to perform emergency repairs.

Understanding the Real Estate Market

Information about the residential housing market is readily available to consumers through public property records and real estate portal sites such as Zillow and Realtor.com. Understanding the market for investment properties is more complicated because it’s not enough to know whether a certain price is fair based on similar, recently sold properties.

You also need to forecast the net operating incomes of the properties you’re considering. NOI and market value are the two components of a metric called capitalization rate, which is one way investors compare properties and evaluate their potential as investments.

Property Management

Property management entails a range of responsibilities that can be quite time-consuming. They include:

• Repairs and updates to prepare the property for tenants

• Marketing to prospective tenants and showing the property to interested prospects

• Screening tenants in accordance with local, state and federal fair housing and privacy laws

• Executing leases

• Collecting rents

• Managing property owner-tenant relationships

• Performing maintenance and repairs in a timely manner, including at night, on weekends and on holidays

• Handling evictions in accordance with state and local laws

You can hire out property management, but you’ll have to account for the cost when performing your financial calculations. Management fees range from about 10% for management only to 15% for also procuring tenants and executing leases.

Risks of Investing in Real Estate

Real estate investing is a unique business opportunity in that it can generate cash flow from day one. But that cash flow comes to a grinding halt if your tenants default, or if the property sits vacant after the end of their lease — or if an unexpected emergency renders your units unrentable.

The way to mitigate that risk is with insurance. The specific type and coverage you need depends on the type of property and its use. A policy for a single-family detached home will be very different from a policy for a commercial property, for example.

Generally speaking, you’ll need coverage that does the following:

7 Steps for Buying an Investment Property

Purchasing property for investment can be an effective way to increase your income. To do it correctly, follow a few key steps.

1. Decide How To Finance Your Real Estate Investment

So how do you finance real estate investments? You have several different loan options if you want to finance a house:

Conventional Loan

Conventional loans are the gold standard. They provide the best balance between competitive rates and flexibility for investment properties with one to four units. You can give a fixed or adjustable rate, but you’ll need good credit and a low debt-to-income ratio to qualify.

FHA Loan

FHA loans are insured by the Federal Housing Administration. While not technically loans for real estate investors — they’re intended for qualified buyers with limited income and/or credit — FHA loans can finance a one-to-four unit property that you’ll occupy for at least one year.

While FHA loans allow low down payments and often have lower rates than conventional loans, high mortgage insurance premiums make these loans an expensive option for many buyers.

VA Loan

If you’re an eligible veteran, you can purchase a property with one to four units with no money down using your VA loan benefit. As with an FHA loan, you — or your spouse or dependent children, in the event you’re called to active duty — must occupy one unit.

Rates are usually lower than conventional loan rates, but you’ll pay a funding fee, which you can roll into the loan.

Private Money Lender

Private money lenders are individual investors or investing groups that finance other investors’ real estate purchases. Because they use their own funds rather than bank funds to make real estate investment loans, they also set their own lending criteria, which can be more relaxed than you’ll find with a bank loan. However, they might also charge higher interest rates.

This financing option is best for experienced real estate investors who can document prior success with investment properties.

Seller Financing

In rare cases, you might find a seller who’s willing to let you pay the purchase price in installments. This kind of deal is called a purchase-money agreement, and it’s much riskier for the buyer than for the seller, especially when it involves a lease option. Always consult an attorney before entering into a seller financing agreement.

2. Find a Real Estate Agent

When you’re buying your first investment property, it’s important to use a real estate agent. Real estate agents have knowledge of the local sales and rental markets and can help you locate properties and evaluate their suitability for your investing goals.

An experienced agent can also offer recommendations for other professionals, such as lenders, attorneys, appraisers, inspectors and property managers.

3. Know the Types of Investment Properties Available

The two categories of investment property are residential and commercial. Residential properties include single- and multi-unit properties such as apartment buildings and duplexes.

Commercial real estate, on the other hand, includes retail, office and industrial space.

4. Study the Local Market

The real estate market is decentralized, which means it’s crucial to evaluate the neighborhood and community for your long-term profitability. Because the local economy will influence the demand for rental properties, buying a home in a lively neighborhood, or even an up-and-coming neighborhood, is a good investment.

For instance, the presence of a major corporation — like Google or Amazon — will have a positive impact on rentals in the neighborhood. As all the renters move in, so do the shops, restaurants and bars, ultimately forming a community. The key here is looking at big employers, local amenities, lively communities and property values.

5. Select an Investment Property

Selecting the right investment property requires looking at a number of factors like the neighborhood, home value, continuing costs and demand for rental units. The upfront investment of purchasing the rental property includes closing fees, taxes and transaction costs. The continuing expenses are the financing, maintenance, repairs and other operating costs as well as insurance, taxes and legal fees.

The best investment properties have the potential to increase in value over time with rising rental rates. You’ll need to consider all these factors when calculating capitalization rates to compare properties. The basic idea is to objectively evaluate the costs and determine the best ways to generate income and realize an appreciation in value.

6. Conduct Due Diligence

When it comes to real estate, what you don’t know can hurt you.

A property inspection is imperative because it should reveal structural issues as well as problems with plumbing, electrical and heating/air systems, wood-boring pests and water infiltration.

An appraisal is also vital. Only a licensed appraiser can determine a market value. Your lender will order the appraisal if you finance the property. If you’re paying cash, you’ll need to order your own.

The property itself isn’t the only factor. Taxes and insurance also affect the viability of a property as an investment. Never rely on assumptions about these costs. Get estimates from a few insurers, and inquire about property tax directly with the county taxing authority.

7. Decide Whether To Self-Manage or Hire a Property Manager

Consider the time investment required to manage the property, and weigh it against the cost of hiring a property manager. The decision doesn’t have to be all or nothing. You might hire a real estate agent to handle tenant screening and leasing and perform other management tasks yourself, hiring from your own network of contractors and tradespeople to perform maintenance and repairs as needed.

Final Take

Unlike other classes of investments such as stocks and precious metals, investing in physical real estate is much more of a business activity that requires at least some active involvement from the investor, even if a property manager handles day-to-day operations. The keys to success are understanding how to evaluate properties based on income and appreciation potential, and competent management to minimize costs and mitigate risk.

FAQ

Still have questions about financing real estate investments? These answers might help.

• What is the 2% rule for investment property?

  • The 2% rule says that for a positive return on your investment, you need to rent a property for at least 2% of its purchase price. In practice, the rule is not very useful because the only cost it considers is the purchase price.

• Is it hard to finance an investment property?

  • It’s more expensive to finance an investment property than a primary residence, but it’s not difficult for well-qualified investors to obtain loans for rental properties with up to four units.

• Is $5,000 enough to invest in real estate?

• Can I put less than 20% down on an investment property?

  • Yes, if you’re purchasing a property with four or few units with an FHA or VA loan, or, in some cases, even a conventional loan.

Chris Seabury contributed to the reporting for this article.

This article originally appeared on GOBankingRates.com: The Ultimate Guide To Purchasing and Financing Investment Properties