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Rental Property Buying Process - Step by Step Guide

Updated: May 26

Investing in Rental Properties

Investing in rental properties include buying rental homes - collecting monthly rents and waiting for appreciation, buying commercial properties - leasing it to shops, restaurants etc, buying apartment complex - leasing to tenants and collect monthly rental bills. The choice depends on the individuals and their level of risk and comfort.


Things to consider while buying a rental property

  • Rental yield is the income generated from your investment property by calculating the difference between the sum of overall costs on a property and the rent received from the property. Understanding and calculating rental yield helps gain a good perspective on knowing the investment potential of the rental property.

  • Location of the property - Another important aspect to consider while choosing the rental property is the Location. As some aspects of the home such as the interiors of the home, floor plan of the home and even the number of bedrooms and bathrooms may be modified. But the location is something which cannot be changed or modified.

  • Age and Condition of the property - The age and the condition of the property plays a major role in decision making. There are a number of maintenance costs associated with the maintenance of the older property such as HVAC systems, plumbing, roof repair and maintenance, electrical issues.

  • Neighborhood - It is important to analyze the crime rate of the neighborhood as safety is a very important aspect. Areas with high crime rate not only reduces the rental income but also increases the vacancy rate of the property.

  • Schools - Properties located in areas with good schools usually have a high purchase price, but it can be compensated by charging a higher rent.

  • Number of Bedrooms and Bathrooms - The choice of number of bedrooms and bathrooms needed depend on the individual's choice. Tenants with children usually prefer to have at least 2 bedrooms or more as some prefer to have separate bedrooms for their kids.

  • Property management - Some investors plan to hire a property management company to take care of their property. Though the management is a little pricier, it takes care of all the problems and issues that arise on the property.

  • Transport Facilities - Access to the public transportation is usually high in the tenant expectation list as it creates a great impact in commuting to the workplace and the quality of lifestyle.

  • Vacancy rates in the area - It is important to be aware of the vacancy rates in the area as the high vacancy rates may lower the value of the property that you are planning to invest in.

Benefits of investing in Rental property

  • Cash Flow - It creates a positive cash flow as the tenant's payment on rental exceeds the monthly mortgage payment and expenses on the property.

  • Appreciation - The property appreciates overtime or by the improvements made by the owner, the value of the property increases. The equity on the property increases overtime due to mortgage pay down.

  • Leverage - One of the important factor to consider investing in rental property is leverage. You can buy with only a percentage of the total money required (usually rental properties need 25% down payment) but you will get the appreciation and cash flow for the 100% of the value of the property.

  • Control, Financial Freedom and Passive Income - You have the total control over the investment where you can decide where to buy, what renovations can be done, how much to charge as a rent, You have very little control over stock market and other investments. Investing in rental property creates a positive cash flow through the rental payments collected from the tenants.

  • Capital Gains - When you sell a property, the profit is not taxed like the ordinary income. Tax rate for Capital Gains are usually around 15%, while the average income tax is around 30%. 1031 exchange is another way to defer capital gain taxes and depreciation recapture taxes.

  • Tax breaks - There are numerous tax benefits in investing in rental properties. You can write off Tax deductions on Mortgage interest, Maintenance and repairs, Property Tax, Legal and Professional fees, Homeowner and Landlord Liability Insurance, Depreciation, Travel expenses, Home Office.

  • Depreciation - IRS allows you to depreciate the value of the property over certain years even though your property is appreciating. The cost of the building is depreciated over 27.5 years if its a residential property and over 39 years if its a commercial property.

Preapproval

Mortgage Preapproval is a document or letter from the lender stating how much they are willing to lend money to you to buy your home. Getting preapproval is the crucial step in buying a home. The preapproval is an indication that the lender is willing to move forward with the loan if the home meets the criteria expected and there is no drastic changes in your income or assets. The lender checks the borrower's creditworthiness based on income, assets, credit history, employment history. Preapproval doesn't guarantee that the loan will be given to borrower, a proper appraisal has to be done to be approved for mortgage. The result of the preapproval process is that the borrower receives a Good Faith Estimate from the lender with details such as term of the loan, Interest rate, Loan type, closing costs etc.


Loan options for Rental Investment Property


Rental Property Loans

The mortgage process for the investment properties are the same as the primary residence where the lenders check the debt to income ratio, assets, credit check. The requirements are checked through a process of underwriting before the loan is sanctioned. Lenders usually follow stricter standards for the loans on Investment Property when compared to the Residential loans as they view the rental property investment to be a greater risk as the owner does not live in the property. The interest rate and the loan fees may also be higher than the residential loans to compensate their higher risk. There are scenarios where some investors just choose to walk away if the rental property does not generate positive cash flow.


Loan Qualifications

  • Lender usually qualifies the rental property loan by qualifying both the property and the owner. These qualifications vary depending on various factors such as the lender, location of the property, percentage of down payment.

  • Most of the lenders expect 25% down payment for the rental property.

  • Some lenders might also need proof of reserves of at least 6 months for mortgage payments, property tax etc.

  • Credit score of at least 620 may be mandatory.

  • Single family, multi family (units 1-4), condos, town homes qualify for Residential loans.

Operating Expenses

In addition to the monthly mortgage payments, there are also other costs that need to be considered by the investors while investing in rental properties.

  • Property Tax

  • Insurance

  • Property management Fees

  • HOA Fees

  • Maintenance and Repair Fees

  • Leasing and lease renewal Fees

  • Capital reserves for emergency purposes

  • Business and License Fees

  • Vacancy Costs

Loan Options for Rental Investment Property

Some of the Loan options available for Rental Investment Property are listed below.

For detailed explanation, click on the link Loan Options for Rental Investment Property.

  • Conventional 30 year Fixed mortgage

  • Adjustable Rate Mortgage

  • Jumbo Loan

  • FHA Loan

  • VA Loan

  • Seller Financing

  • Portfolio Loan

  • Home Equity loan

  • HELOC

  • Blanket Loan

Home Searching Process

Best way to track down the positives of a home or to compare the homes that best fits your expectations is by creating a checklist of your investment property criteria. There are certain things that can be done while touring homes to determine the quality such as checking on the structural and exterior defects on the walls, roof, Water pressure by turning on the faucets, flushing of the toilets, electrical issues by turning on the switches etc. These only provide a rough idea of the health of the home, a proper home inspection may be needed to determine the condition of the home precisely.


HOA - CC&Rs

It is very important to know the covenants, conditions and restrictions of a Home owner's association before deciding to buy a home in a particular community. There might be a lot of restrictions such as parking rules, restriction in owning certain types of pet, architectural controls, Limitations in Insurance coverage, home maintenance standards, home occupancy limit, noise complaint policies, lawn and holiday decoration restrictions. It is also important to know the meeting minutes of HOA for at least a year and know about the reserves, plans for future as well as your future HOA fee may increase accordingly.


Make An Offer

Once you find a home that you like that meets your budget and other terms, then you may have to decide on how much has to be offered for the home, what contingencies may have to be added in the offer proposal such as appraisal contingency, inspection contingency etc and how much earnest money are you planning to deposit. Earnest money is the amount of money a buyer is willing to deposit to purchase a home which is typically 1-2% of the home which is deducted from the down payment or the closing cost while closing your home.

The more the buyer is willing to put down as an earnest money, the more serious the offer looks in the Seller's point of view. Once the seller receives the offer, depending on the terms disclosed, the seller may decide to accept it, reject it or make modifications. The modifications made are sent as a counteroffer to the buyer with modified terms and conditions. If for any reason the buyer decides to back out from the deal for any reasons other than that are outlined in the purchase contract, then seller may keep the earnest money. If the deal falls through due to any contingencies listed in the purchase contract, then the buyer may get their earnest money back.


Seller's Disclosure

A seller's disclosure is a legal document that enlists the details about the condition and history of the property including the list of defects present currently that the buyer must know about the home, it usually includes the problems that might have occurred before and the details about the remedy that was done to fix it. It may also include the details about whether the repair that has been fixed need a regular maintenance or does it have the potential to cause any future problems. Usually the questions about the property are answered as Yes, No or Unknown. In California, death in the property has to be disclosed if it was within the last 3 years.


Rental Property buying process - step by step guide

Get A Home Inspection

A home inspection is a process where a qualified home inspector examines the safety and condition of the real estate property and provides a report. It is a very important step to consider during both the buying process of a home. They usually examine the interior structure, exterior structure, plumbing system, electrical system, sewage etc from the foundation to the roof and look for the signs of damage caused by water, fire, insects etc to assess the real condition of the property before buying and selling. After the property's condition is assessed, the home inspector provides a Home Inspection Report. A home inspector may only be able to assess the problematic areas, for example, defects in the structure of a home may only be corrected by hiring a proper structure engineer.


Home Inspection contingency is a clause added to the purchase contract before buying the home. It typically means that the offer to buy the home depends on the results obtained from the home inspection report. The buyer may decide to cancel the contract or negotiate the repairs to be taken care of with the sellers. Usually the contract offers the buyers a time period of 7-10 days to respond to the sellers of any objections or negotiations regarding the inspection report from the date the purchase contract is signed. The contract is not legally binding until the period ends. The rules of the Home inspection and the number of days vary from state to state and in some states, they are added as a clause in the purchase agreement. Usually the negotiation between the buyers and sellers are done within the time period in writing.


Home Appraisal

Appraisal is a process in which the home value is estimated by an opinion of a professional. This process helps in determining whether the home price listed is appropriate for the current home's condition, location and their features. It may help the lenders to make sure that the borrowers are not overpaying for the property as the home serves as the collateral for the loan. The value is determined by various factors such as location, square footage, number of rooms and bathrooms, functionality, floor plan, amenities etc. The appraiser also makes sure to have a visual inspection in the interior and exterior of the home to find any areas that may affect the property's value and any areas that need repairs. Depending upon the situation you may consider taking an Umbrella Insurance, since the risk reward ratio is high.


Landlord Insurance and Renter's Insurance

Landlord or Dwelling fire insurance policy covers the rental units that you own. This insurance typically includes both Property and Liability coverage protection against your financial losses or claims. It usually covers the physical structure of the property, other structures or the personal property that you own in the unit as a Landlord. It may also cover the medical expenses for another person or your legal costs in case someone got injured in your property that you are responsible for.

It is also referred as a Tenant Insurance or HO-4 insurance policy. Many renters think that their landlord's insurance policy will cover all their belongings, which is not really true. If you are currently renting an apartment or home and for any reason, your home is destroyed by catastrophic events or affected by theft, vandalism etc, it helps protect your Personal property. It may also provide protection to you if someone gets hurt in your apartment, condo or home against any claims. It protects you against liabilities. Typically, a standard Renters policy covers Personal Property, Liability and Living Expenses. A Renters Policy is usually cheaper than the Home owners Policy as the external building or structure is not covered.

This coverage helps cover the contents or personal belongings of your home such as clothes, furniture, electronics etc. If the damage is caused by the named peril outlined in your insurance policy. If your home is prone to any perils that are not outlined in your policy, it may be added as an additional coverage to your policy. The insurance does not cover all the items you own and certain valuables such as Jewelry, art work, paintings etc may be beyond the coverage limit.


Additional Coverage

In this case, if you want those items to be covered under your policy, you may add an additional coverage called as the Scheduled Personal Property Coverage. The coverage for the damaged items may be compensated as the actual cash value or replacement cost depending on the policy.


Liability Coverage

This is another coverage that is usually included in the renters policy which helps you from paying out of pocket for the damage caused. It provides coverage in cases where you are legally responsible for the damage.

For example, if a guest trips on your rental home or apartment, falls and gets hurt, this may cover the medical bills. If your child accidentally breaks your neighbors window, this may cover the cost for the damage. The amount of coverage obtained is purely based on the type of policy, policy provider, coverage limit etc.

If your dog caused some serious injury to your visitor, it may also help you cover the costs against any lawsuits, legal fees, court costs, medical expenses. The typical coverage limit in Standard Renters Policy is usually $100,000. This coverage limit can be extended to higher limits through Umbrella Insurance Policy. If the damage caused is $150,000, then the excess $50,000 may be covered by your Umbrella policy.

Renters insurance covers you when you don't own the home and the coverage is same as the Home owners insurance except for the structure of the home. The Landlord is responsible for the coverage of structure of the home which may be covered by Landlord Insurance.

Cost

Factors that influence the cost of Home owners and Renters Insurance are

  • Location

  • Personal property coverage needed

  • Deductibles

  • Credit score

  • Proximity to fire hydrant and fire station

  • Hazard prone

  • Maintenance of the property

Optional coverage

These coverage can be added on to the standard insurance policy as an endorsement to increase the coverage and better protect your rental home. These additions depends on the specific needs of an individual renter. They vary depending on a number of factors. Some of these coverage may not be available under your policy or you may not be eligible for receiving the coverage.

  • Endorsements and Floaters - Endorsement and floaters are an additional insurance coverage for a specific high priced item for which the coverage limit under the standard policy is way below. In this type of coverage, the specific item such as jewelry, art work etc must be taken to be appraised, Once appraised, the insurance company will determine a premium based on appraisal value.

  • Flood Insurance - Damages caused by floods are not covered by the standard renters insurance policy. Depending on the location and chances of getting flood damage, it is advisable to get a separate Flood Insurance Policy. You may also have an option to add on the flood insurance to your renters policy.

  • Earthquake Insurance - Damages caused by Earthquakes are not covered by the standard renters insurance policy. Depending on the location and chances of getting earthquakes, it is advisable to get a separate Earthquake Insurance Policy. You may also have an option to add on the Earthquake insurance to your renters policy.

  • Mold Damage - Mold damages are covered only if the damage is caused by any of the covered perils like leakage of the plumbing system etc. Mold caused by negligence and poor maintenance, flood damage are not covered by the standard renters insurance.

  • Pet damage - The pet damages like damage to the carpet, claw marks on the wall or other destruction may be covered by adding a pet damage endorsement to your policy. It helps cover the costs of repair or cleanup.

  • Water Backup Coverage - If your clogged sink, bathtub or toilet overflows gushing water into your home, this endorsement may help cover the repair costs.

Filing a Claim

If your rental home is damaged by a covered peril, it is very important to file a claim as soon as possible after collecting necessary proofs and documents needed like photos, videos or description of the event with as much details as possible. Most of the insurance companies have a specific time frame within which the filing has to be done. Sooner you start, sooner you will be compensated for your damage or loss. The claims adjuster assesses the damage and once your insurance provider approves payout, you will be receiving the check for the compensation amount minus the deductible.

The events and items covered by your insurance policy differs based on your policy and insurance provider. The conditions and limitations of the coverage vary upon your specific policy. Inform insurance company ahead of time if you have any expensive structures in your property. This will act as a documentation for coverage in case any mishap happens.


Title Insurance

A title is a document that stands as an evidence that the owner has the lawful right in possession of the property. Title insurance provides protection to the mortgage lenders and home buyers against any defects, encumbrances, liens or problems with the title during the transfer of ownership of the property. Unlike the homeowners insurance or car insurance which provides protection against future losses, title insurance provides protection to the insureds against the claim of past events or occurrences. It is a one time fee paid at closing to insure your home against any claims outlined in the policy for as long as you live in that home, it may extend to heirs as well.


Final walk through

Final walk through is an opportunity for the home buyers to go through their home before closing the home buying process for one last time. The buyers may check the home to make sure it is in the same condition when the buyers agreed to buy it or make sure the necessary agreed upon repairs are done by the sellers during the negotiation period. It is an important step in the home buying process to check the home one last time before becoming legally and financially responsible for the home. Some of the things that may be checked are checking walls and floors for damage as it is possible to have damages due to the seller's moving out process. If there were any issues found in the walk through process, you may delay the closing, renegotiate the contract terms with seller or arrange for an escrow hold back for the repair cost that might be paid by the buyer.


Set up Utilities

Some areas have specific set of rules about who pays for utilities such as gas, electric, trash collection, water and some areas don't have any set of rules. Usually everything is put in writing in a Landlord - Tenant agreement. It is usually easier for the tenant to pay for the utilities. Sometimes, a multiple unit owned by a Landlord might have a single meter. In that case, Landlord pays for the utility bills and passes on their individual utility bills along with their monthly rent.


Close your home & get keys

Typically it takes around 30-60 days to close a home and may take longer depending on various factors including whether you have a preapproval ready, how long does the home inspection process takes to complete, repairs and negotiations etc. Once the contract is signed by both the buyers and sellers, they are combined with any other documents in the escrow process. The Escrow officer sends all the documents to the lender. The lender funds the loan once they receive all the documents necessary. The final step of the process is when a Grant deed is recorded and stamped at the county hall of records. This final step officially transfers the ownership of the property from the seller to the buyer. Usually the keys are handed to the title company by the seller and the title company hands it over to the buyer once all the signing, funding and recordation are done. The timeline and the process may vary according to the location and the rules followed.


What is a rental yield?

Rental yield is the income generated from your investment property by calculating the difference between the sum of overall costs on a property and the rent received from the property. Understanding and calculating rental yield helps gain a good perspective on knowing the investment potential of the rental property. It also helps the investor to choose the best rental yielding property by comparing the property values with respective rental yield ratios and make a wise decision.

It can also be called as rental income calculator or cash flow calculator. Understanding rental yield concepts are important to create a successful investment strategy. It helps the investor to track on the investments that are over performing or under performing on their Rental Portfolio.


Rental yield can be calculated in two ways,

  • Gross rental yield

  • Net rental yield

Both types of yield measure

  • ROI (Return of investment)

  • ROR (rate of return)

Gross Rental Yield

Gross rental yield is obtained by calculating the annual rental income against the value of the property. Annual rental income is calculated by multiplying weekly rent by 52 or Monthly rent by 12. The value of the property represents either purchase price of the property or the current market value of the property.


Net Rental Yield

Net rental yield is a much precise way to calculate the rental yield as it includes all the operational costs and acquisition costs involved in purchase of an investment rental property.

Net rental yield is calculated by taking to account of all the costs that are involved in buying rental property. Operational expenses vary widely depending on the location, age of an investment property, Insurance, Infrastructure, Vacancy rates etc.


Finding Tenants for Your Newly Purchased Home


Preparing the Property

  • Deep clean your home

  • Landscaping

  • Heat, Plumbing or Electrical issues and Appliances

  • Paint and repair damages

  • Wash out windows and replace torn screens

Advertising your property

Here are some of the options you may use to advertise your property. Regardless of the type of advertising on online or paper, some of the important details to be included are Property description, photos of good quality, square feet, number of bedrooms and bathrooms, Rental amount, date from which the property is available, Contact information.

  • Rental Sites - There are a number of rental sites available where the Landlords can advertise their property for rental. Usually, these websites help the tenants to filter their searches based on the location, square foot, rental price, number of bedrooms and bathrooms.

  • Social media - Social media such as Facebook, Instagram, Twitter are used by majority of the people on a daily basis. The rentals can be advertised by posting the photos with the description of the rental property.

  • Personal Website - If you have your own personal website with a good traffic, then you may post photos, description, details and conditions of the property.

  • Newspaper - Newspaper is also a good option when it comes to advertising your property as it is not only cheap but also helps increase the exposure of the property.

  • Benefits of using a Realtor - You may also pass on the responsibility to a realtor, as the realtor has access to MLS (Multiple Listing Service). Posting an ad in MLS auto populates the ad in a number of websites increasing the exposure of the property exponentially, some agents also conduct open houses to advertise the property.

  • Flyers - Distributing flyers in the areas of local community and neighborhood where the property is located, local grocery stores, community centers increases the exposure of the property.

Rental Application and Screening

Usually there will be a small non refundable application fee charged to the tenant. The most commonly requested documents include Driver's License, Contact information (Phone number and E-mail address), Proof of income like W2s, pay stubs or bank statements. Sometimes in a competitive renter's market, a letter of recommendation from the previous landlord or an employer may increase the chance of application getting approved by the landlord.


What is a Property management?

When a Landlord owns a property, they can either self manage the property or use a Property management for screening tenants, advertising the home, routine maintenance, repairs, rent collection, handling tenant contracts, eviction process. Property manager acts as an intermediate between the owners and renters, this is especially very useful for the owners who are out of state who won't be able to manage their property on their own.

Investing in rental property provides a passive income and increase cash flow through the rental payments collected from the tenants. Since being a landlord requires consistent effort as the property has to be maintained for the tenants, you can involve the Property Management Company to delegate your responsibilities. It reduces a whole lot of burden on your shoulders, thus making it a passive income with minimal effort.


Signing a Lease agreement

Once the tenant is approved, a rental lease agreement is signed. Lease agreement is a legally binding document between a Landlord and Tenant where both agree to the terms and conditions outlined in the agreement. It is best to ask the renters to show a proof of Renter's Insurance before moving in to the home. The policy may be dated to the move in date so that the insurance coverage starts from the move in date. Most of the Landlords request a security deposit of one month's rent in advance while signing a lease agreement. The security deposit might help protect the Landlord and serve as a coverage from any loss caused by the tenant breaking or violating any terms of the agreement.

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