Investing in real estate is a great way to build wealth, but it comes with risks and challenging financial decisions. Learning how to buy an investment property the right way is key to ensuring you make money and remain financially protected.
What Beginners Miss When Buying an Investment Property
New real estate investors share some common misunderstandings and make similar mistakes.
Buying an Investment Property Differs from Buying a Home to Live in
Beginners often don’t realize that buying an investment property isn’t the same as buying a primary home. Here are some of the differences:
- Down payments are higher. Instead of the 3% to 5% for a primary home, lenders typically require 15% to 25% for investment properties.
- Interest rates tend to be higher because lenders see investment properties as riskier. Expect rates of 0.5% to 0.75% higher when buying an investment property.
- Credit checks and income standards are more stringent. Many lenders want credit scores above 700 and proof that you can afford your own housing as well as the new mortgage, even if you have solid rental potential.
These realities can come as a surprise to new investors, but once you’ve become accustomed to them, they’re just part of doing business!
Common Calculation Errors
When buying an investment property, it’s essential to analyze the property’s potential profitability as accurately as possible. Typical miscalculations come from underestimating expenses (including financing, maintenance, and property management costs), not calculating ROI, basing calculations on full occupancy without considering vacancy rates, and failing to budget for capital expenditures.
Due Diligence Errors
When buying an investment property, do your due diligence beforehand. This includes getting thorough property inspections, researching the neighborhood, checking existing leases, and learning the landlord-tenant rules that apply to the building.
Understanding Tax Regulations and Legal Details
Buying commercial real estate comes with some tax perks, but understanding the details is important:
- Rental income is taxable, but deductible expenses will reduce your overall tax bill.
- Depreciation allows you to deduct part of the property’s value annually, but can lead to recapture taxes when you sell.
- Property taxes can increase and may even have increased from the last time the seller paid their tax bill. Verify the current property taxes before you close the deal.
- Your ownership structure affects how income, expenses, and capital gains are treated for tax purposes. Consult with a real estate accountant or lawyer to decide on buying an investment property as an LLC or as a sole proprietor.
Buying an Investment Property Before Your First Home
New investors sometimes choose to buy an investment property before they buy a home for themselves. This is not an unusual strategy, but it has some trade-offs.
The advantages of buying an investment property before a first home are that you start building equity and rental income earlier in life, you gain landlord experience, and you can use rental income later to qualify for a mortgage on a primary residence.
On the downside, the down payment and interest will be higher on your investment property than they would be on your first home, you’ll continue to pay rent for yourself while managing your investment, and you could lose access to first-time home buyer programs.
A third option is house hacking, which involves buying a building with more than one unit, living in one, and renting out the rest. That way, you get the benefits of home ownership and investing in one package.
Financing Options When Buying an Investment Property
Getting financing is often one of the biggest obstacles to buying an investment property. Here are a few options to consider:
Can I Use an SBA Loan to Buy an Investment Property?
Usually not, because SBA loans are meant for operating businesses, not for real estate Investors earning passive income. However, if you’re buying a property to run a business from, certain SBA loans can help you purchase the building itself. As long as you are using 51% of the space, you can rent the rest out to tenants.
Buying an Investment Property as an LLC
Buying the property under an LLC business structure can protect you legally by separating your personal assets from your business assets, but it can also make financing more difficult. Consult with an accountant who specializes in real estate or with a real estate lawyer to review your options.
Can I Get Seller Financing When Buying a Real Estate Investment?
Yes. With this option, the seller acts as the lender, and you make payments directly to them. These arrangements are not uncommon, but usually carry higher interest rates and may require quicker repayment.
Investing in Real Estate With a Partner
Buying property with a partner cuts down on initial costs while sharing the risks and responsibilities. Here’s how to buy an investment property with a partner:
- Treat it like a business rather than a project you’re launching with a friend.
- Form an LLC or partnership with the help of a lawyer, ensuring that the agreement outlines how you’ll share ownership, split profits, and manage buyouts.
- Outline how decisions will be made in your partnership.
- Keep personal finances separate from business finances and document every expense.
Partnership can be a great way to get into real estate investing, but conflicts and misunderstandings are not uncommon. As long as you’re prepared and have everything in writing, you can make this arrangement work.
The Best Places to Buy an Investment Property
When buying an investment property, location is a key factor in your success. Beginners often buy close to where they live for convenience, but that might not be the best place from an investment perspective.
For residential properties, choose an area that has high job growth, a growing population, and a rent-to-price ratio that matches your investment goals (i.e. cash flow and strong income vs. long-term appreciation).
If you’re interested in buying an investment property out of state, do your research in advance, visit the area more than once, and work with a local real estate agent who understands the rental market intimately.
Buying a Short-Term Rental Property
Short-term rental properties can be very lucrative. Buying an Airbnb investment property or something similar has become extremely popular. However, this type of investment comes with unique challenges, including:
- Varying regulations, including bans in some areas on short-term rentals and requirements for special permits.
- More challenging financing: some lenders won’t back properties intended for short-term rental use.
- Higher operating costs, including furniture, cleaning, supplies, utilities, insurance, and management fees.
- Variable income, with highs during tourist seasons and lows during off-peak times. Income can also change suddenly depending on changes in regulations and travel trends.
Buying an Airbnb investment property can be a great option, but do the research and the math before committing.
Understanding the process of buying an investment property means looking into business structures, financing, market conditions, local job growth and vacancy rates, and tax and legal issues. It can be complicated, but it is also an exciting challenge that can build your wealth steadily with the right preparation and a solid team on your side.
