How to Buy Your First Real Estate Investment Property

First, stop and answer this question – do you want to be a landlord?

I have met people over the years who hate owning property. They can’t sleep at night because they worry about the HVAC system dying or some other large, unpredictable expense popping up. When I ask why they went down this path, they say they thought it was the best way to build wealth and get real estate exposure in their portfolio. Neither is true.

Document your goal with the property.

If your only goal is to add real estate to your investment portfolio for diversification purposes, there is an easier way to achieve this than buying a house. You can buy a real estate investment trust, otherwise known as a REIT. It does not come with the tax benefits of real property and the risk and return characteristics are different, but it is more diversified, more liquid (easier to buy and sell), and you do not have to be a landlord.

If your goal, however, is to have passive income, take advantage of dislocations in the real estate market, invest in an area you see gentrifying first-hand, or hold onto a home you may want to move back to someday, then owning a rental property might be a good option.

Here are the basics on how to evaluate, buy, and manage properties that will be a good fit for you and your portfolio.

Have a strong financial foundation before getting started in real estate.

Real estate should be a supplement, versus a core part of your portfolio because it is not liquid - you cannot instantly sell a home or access the equity. You should first have the following:

- A secure job, an emergency fund, and zero high-interest rate loans

- Retirement savings where you are maximizing your annual contributions (or saving a healthy amount, at least taking advantage of your employer’s match)

- An adequate amount of insurance coverage, such as life and disability

When looking for potential investments, focus on buying in areas with growing demand and amenities that strengthen the community.

- Find desirable areas with low crime rates, good public schools, growing job markets, and public parks. This will help you attract and keep tenants and it will help with your home’s resale value.

- Understand the current laws (and pending laws) regarding rentals in the area. Short-term rentals, in particular, have changing laws that could greatly impact your investment’s profitability.

In preparing to buy an investment property, aim for at least a 20% down payment.

Mortgage lenders typically require a 20% down payment on rental properties because the loans are considered higher risk than for a primary residence. If you are going to default on a loan, you will likely default on your investment property before you default on your home mortgage.

The mortgage interest rate for an investment property is also higher for the same reason. You will likely be able to get a lower rate the more you put down (which might be a good option during this interest rate environment).

In evaluating potential properties, pencil out the projected pre-tax cash flow.

Rental Income - Rental Expenses = Pre-Tax Cash Flow

Rental Income - Search for rental listings online that are comparable to your potential investment properties. This will give you an idea of what you can expect to receive in terms of rental income. Helpful sites include HotPads, Zillow, Craigslist, and Realtor.com.

Rental Expenses - Determine estimates for the mortgage, property taxes, insurance, and pest control. Other expenses that may need to be included are homeowner’s association (HOA) fees and landscaping. A rule of thumb is to estimate that your repairs will be about 1% of the home value per year. You may also want to factor in a cushion in case the property is vacant or there is a large unexpected expense.

More about vacancy…

I hardly ever include vacancies in projections for southern California clients – housing is crazy here. But I hear of other places where vacancy is a big issue that came out of nowhere. One friend has a short-term rental in Florida that was great for a couple of years until the market became flooded with properties. They had to pivot to a long-term, furnished rental instead, which is a good alternative, but that speaks to being in a good financial position before the purchase so you can manage this risk.

Putting it all together.

How does your annual pre-tax cash flow look? You can stop here and see how it flows through to your financial plan. Even if the cash flow is negative right now, you may be willing to accept that deficit temporarily with the understanding that your cash flow can support it and the rental price will keep increasing with inflation, but your mortgage will stay the same.

Here is the formula if you want to go one step further and evaluate your cash on cash return.

Annual pre-tax cash flow / Total cash invested = Cash on cash return

Consider using a property management company.

Property managers charge between 6 and 10% of the monthly rental income. It is possible to manage the property yourself to save money, but many people use a property manager to have a degree of separation between the tenants and avoid calls in the middle of the night with home emergencies. If you are unsure, include the property management fee in your projections to be conservative.

Obtain a lease.

LegalZoom has a rental lease agreement that is customizable and easy to read. You can contact a real estate attorney if you feel more comfortable working with a professional.

Run a background and credit check on potential tenants.

Do not skip this step, even if you know the tenants personally. Most of the horror stories I hear from landlords are because these checks were skipped during the due diligence process – the tenant was a friend of their sister, or a friend of a friend.

There are unique tax benefits available to owners of real estate investment properties. Find a knowledgeable tax preparer.

• Rental income is not subject to Social Security and Medicare tax in most cases. There are exceptions, such as if you are providing substantial services to your tenants for their convenience or you are a real estate professional.

• A portion of your rental income can also be shielded from income tax. You are allowed to deduct items such as mortgage interest, property taxes, homeowner's association (HOA) fees, insurance and depreciation. With regards to depreciation, it is a "non-cash expense" meaning it is not something you pay for out of pocket. It lowers your tax bill by increasing rental losses, which can offset earned income by up to $25,000 in some cases (it depends on your income and your “level of participation” with regards to the management of the property).

• Keep records of capital improvements. If you sell the property at some point, you will need the tax basis to determine the amount of tax due. Capital improvements increase tax basis and therefore, reduce taxable gain. Examples include replacing an entire roof, paving your driveway and installing central air conditioning. Keep receipts of all capital improvements to the property so they are organized when you sell.

Interested in adding real estate to your investment portfolio?

There are financial and tax implications that need to be considered before designing the best strategy for you. PWR can help you plan, implement, and monitor your investments to ensure they are working for you to the greatest extent possible.

originally published 8/28/2019

Linda Rogers, CFP®, EA, MSBA is the owner and founder of Planning Within Reach, LLC (PWR). Originally from New Jersey, Linda services clients throughout San Diego county and nationwide. She leads the design of PWR's investment portfolios which utilize broad, low-cost investments that integrate environmentally, socially, and governance (ESG) factors.

Planning Within Reach, LLC (PWR) is a fee-only and fiduciary wealth management firm offering one-time comprehensive financial planning, ongoing impact-focused investment management and tax preparation services in San Diego and nationwide. PWR is a woman-owned firm that specializes in busy professionals and impact investors. Planning Within Reach, LLC and their advisors do not receive commissions and do not hold any insurance licenses or brokerage relationships.