Unlocking The Door To Investment: A Guide To Buying Your First Investment Home

Buying an investment home can be a great way to build wealth, but it requires careful planning and research. Here are some initial steps to consider when thinking about purchasing an investment property:

First, evaluate your financial situation and set clear goals. Ensure you have enough cash upfront for a down payment, which is typically higher for investment properties, ranging from 15% to 25% or more.

Next, decide on the type of investment property you want to purchase. This could be a single-family home, multi-unit property, vacation home, or a property to fix and flip. Consider the location, with factors such as low property taxes, good school districts, and walkable amenities being desirable.

Understand the numbers involved, including financing costs, advisor fees, repairs, and mortgage payments. Be realistic about whether you can afford the ongoing expenses and shop around for the best financing options, including traditional mortgages, FHA loans, or owner financing.

Finally, consult experts such as accountants, real estate agents or attorneys, and mortgage professionals to ensure you have a solid understanding of the investment and any potential risks.

Know your credit score and history

Your credit score is an important factor when it comes to buying an investment home, as it shows lenders how you manage debt. Before applying for a mortgage, it's crucial to check your credit score and credit reports from the three major credit agencies: Experian, Equifax, and TransUnion. You're entitled to a free credit report from each of these agencies once a year.

Your credit score will determine the interest rate and loan terms for your mortgage. The higher your credit score, the lower the mortgage rate you'll qualify for. Typically, a credit score of 620 or higher is considered good, but the score needed will depend on the type of mortgage and the lender. For example, FHA loans only require a minimum credit score of 500, while jumbo loans may require a score of 700 or higher.

If your credit score is low, you may still be able to get a mortgage, but you'll likely pay higher interest rates and monthly payments. You can work on improving your credit score by paying off outstanding debt, paying your bills on time, and avoiding applying for new credit.

In addition to your credit score, lenders will also consider your debt-to-income ratio (DTI) and loan-to-value ratio (LTV) when evaluating your mortgage application. It's important to have a solid understanding of your credit history and financial situation before applying for an investment home loan.

Understand landlord-tenant laws

Understanding landlord-tenant laws is crucial when buying an investment home. These laws vary by state, but there are some general principles to keep in mind. Firstly, as a landlord, you must comply with all state and local landlord-tenant laws, health codes, and building codes. This includes maintaining a safe and habitable property for your tenants, which entails keeping common areas clean and safe, ensuring structural integrity, and maintaining essential systems like HVAC, electrical, and plumbing. You are also responsible for pest control and managing environmental toxins like asbestos and lead paint.

Secondly, familiarise yourself with lease requirements and eviction rules. Leases are legally binding, and you must honour the existing lease terms, including rent amounts and duration. You cannot legally raise the rent, modify clauses, or evict tenants before the end of the lease term just because you are the new owner. If you need to end a tenancy, you must follow the proper legal channels and provide due notice, which can vary from state to state.

Thirdly, know your rights and obligations regarding security deposits. Tenants have a right to their security deposit when they move out, and you, as the landlord, are responsible for refunding it, minus any deductions for damage caused by the tenant.

Fourthly, understand fair housing laws and anti-discrimination regulations. The Fair Housing Act prohibits discrimination in renting, representing properties, or providing services to tenants based on race, colour, religion, sex, familial status, or national origin.

Lastly, be aware of local laws regarding property codes and habitability standards. Rental properties must meet legal requirements for habitability, which are set by state and local laws. Familiarise yourself with these standards and ensure that the property you are buying is up to code and has been properly maintained by the previous owner.

Calculate the ROI

Calculating the ROI on a rental property can be challenging due to the numerous variables involved, but it is an essential metric for understanding the profitability of your investment. Here is a step-by-step guide on how to calculate the ROI for your investment home:

Understand the ROI Formula

The general formula for calculating ROI is:

ROI = (Gain on Investment - Cost of Investment) / Cost of Investment

Identify the Costs and Gains

Costs:

• Purchase Price: The amount you paid for the property.
• Additional Expenses: Any costs associated with repairs, remodelling, closing, and so on.
• Mortgage Costs: If you have taken out a mortgage, include the down payment and any ongoing monthly payments.

Gains:

• Rental Income: The total amount of money earned from renting out the property.
• Property Appreciation: If the property has increased in value over time.

Calculate Annual Returns

Subtract your annual operating expenses (insurance, property taxes, maintenance, etc.) from your annual rental income. This will give you the net annual return.

Calculate ROI for Cash Transactions

If you bought the property with cash, divide the annual return by the total investment amount (purchase price plus additional expenses). This will give you the ROI as a decimal, which you can then convert to a percentage by multiplying by 100.

Calculate ROI for Financed Transactions

If you took out a mortgage, the calculation is a bit more involved. First, calculate your total out-of-pocket expenses, including the down payment, closing costs, and remodelling costs. Then, determine your ongoing costs, such as monthly mortgage payments and other expenses.

Next, calculate your monthly cash flow by subtracting the total monthly payments from the monthly rental income. Multiply this by 12 to get your annual return. Finally, divide the annual return by your original out-of-pocket expenses to determine the ROI as a decimal, and convert to a percentage if desired.

Interpret Your ROI

A good ROI will depend on factors such as location, property type, and market conditions. However, as a general rule of thumb, an ROI above 10% indicates that your investment is generating a substantial income, while an ROI between 5% and 10% is considered healthy in today's market. If your ROI is below 5%, it may be a sign that expenses are too high or rental income is too low.

Consider the location

When buying an investment home, location is one of the most important factors to consider. Here are some detailed tips to help guide your decision:

Centrality and Commodification:

In metropolitan cities, a centralized location can make your property more desirable. Areas with limited opportunities to build new homes or add to the rental market inventory will have higher demand. This means that rental homes in these areas will become more valuable over time. This principle also applies to any popular place where new construction is limited.

Accessibility:

Look for locations with good accessibility to transportation. In some cities, like New York or Chicago, residents may prefer a rental home within walking distance to specific public transportation stops or on certain lines. In suburban areas, public transportation may not be as desirable, and residents may prefer neighborhoods near major transit routes. Accessibility to transportation is especially beneficial for tenants who commute to work or school.

Amenities:

Consider the proximity to essential amenities such as grocery stores, restaurants, coffee shops, and entertainment options. Homes near desirable amenities tend to attract more interest and can increase property values. Additionally, the quality of schools in the area can impact your investment property's location. High-quality schools can attract homeowners and residents, increasing property values.

Appearance:

The appearance and maintenance of the neighborhood are important factors. Potential residents will assess how well the community is maintained, including the condition of roads and nearby businesses. Well-maintained and landscaped areas, as well as access to parks, walking trails, and playgrounds, can make a location more desirable.

Development and Growth Plans:

Research future developments and plans for growth in the area. Consider the impact of new schools, hospitals, public transportation, and other civic infrastructure on your investment property's value. Commercial and residential development can have both positive and negative effects, depending on the specific additions. Understanding how the community is changing can help you evaluate the location's potential.

Specific Lot or Building Location:

Consider both the surrounding area and the specific location of the property within that area. While residents may want easy access to major roads, being located directly on a busy highway can make a property less desirable due to noise and safety concerns. Additionally, limited parking availability or proximity to commercial properties can impact the desirability of the location. Properties with views, located near bodies of water, parks, or open spaces tend to be more desirable.

Plan for maintenance and repairs

When buying an investment home, planning for maintenance and repairs is crucial. Here are some detailed instructions to help you prepare for the inevitable maintenance and repair costs associated with your investment property:

Understand the Difference Between Repairs, Maintenance, and Improvements:

According to the Australian Tax Office (ATO), repairs involve fixing defects or damage to your property. This includes general wear and tear and any damage caused by tenants. On the other hand, maintenance refers to work done to prevent deterioration or fix existing damage. Improvements, in contrast, involve upgrading or enhancing the property to increase its market value or income potential. Understanding these distinctions is essential for tax purposes.

Set Aside a Realistic Budget for Maintenance and Repairs:

A common rule of thumb is to save 1% to 4% of your property's value each year for maintenance and repairs. However, this may not be feasible for all homeowners, especially in high-cost areas. Instead, consider the age of your home, the materials used, and local climate patterns, as these factors can significantly impact maintenance costs. Additionally, the level of maintenance you perform will affect your spending. If you prefer to hire professionals, expect to budget more.

Consider the Lifespan of Your Home's Components:

Research the typical lifespan of major components like the roof, heating and cooling systems, and appliances. You can find this information online or by consulting a home inspector. This knowledge will help you plan for future repairs and replacements. For example, if your 5-year-old air conditioning system has a lifespan of 15-20 years and costs $4,000 to replace, consider saving $400 per year, plus a buffer for inflation.

Understand Condo Association Responsibilities:

If you're investing in a condo, understand the responsibilities of the condo association. They typically manage common spaces and some exterior maintenance, such as landscaping, trash removal, and snow removal. However, you may still need to manage certain exterior repairs and pay condo fees, so be sure to review the bylaws and understand the association's policies.

Obtain Appropriate Insurance:

In addition to homeowners insurance, consider purchasing landlord insurance, which covers property damage, lost rental income, and liability protection in case a tenant or visitor is injured due to property maintenance issues. If you're investing in a condo, review the "master policy" provided by the condo association, as it may only cover exterior damage. You may need additional property and liability coverage.

Be Prepared for Emergency Repairs:

Unexpected repairs are inevitable, so ensure you have savings set aside to handle them promptly. It is recommended to have enough savings to cover short-term repairs before rental income starts coming in. Additionally, consider setting up a home equity line of credit as a backup option for larger, unforeseen expenses.

By following these instructions, you can be better prepared for the maintenance and repair costs associated with your investment home, ensuring a more successful and stress-free experience as a landlord.

Frequently asked questions