In many ways, investing in real estate is straightforward. We know, however, the new investors want the reassurance they’re going into this venture prepared. We don’t blame them – this is, after all, a big step in building a better financial future for yourself and your family!
So what do you really need to do on a practical level to financially prepare to buy your first investment property?
7 Practical Steps to Prepare for Property Ownership
Step 1: Choose a business structure
Investing in real estate may earn you passive income, but it’s still a business. As such, you must be prepared to separate business finances from personal accounts. Some investors want the security of setting up a formal business structure.
Here are the two most common entities investors use:
- Sole Proprietorship – This is the simplest form of business structure, where an individual owns and operates the business. As a sole proprietor, you have complete control over your real estate investments but are also personally liable for any debts or legal troubles. In many states, there are no fees or requirements to set up a sole proprietorship. You will, however, want to register for an EIN tax identification number.
- Limited Liability Company (LLC) – LLCs are popular with real estate investors. They offer a combination of limited liability protection and flexibility. An LLC separates personal and business liabilities, so your personal assets are generally protected from claims related to your real estate investments. Additionally, an LLC allows for pass-through taxation, where profits and losses are reported on the owner’s personal tax returns. States have different filing fees, and some may only cost you the time it takes to fill out the paperwork.
There are also limited partnerships, limited liability partnerships, and corporations. These aren’t as common among individual investors as they are for multiple investment partners and come with more strict guidelines.
Step 2: Assess where you are and where you want to be
Evaluate your finances to understand your current income, expenses, savings, and debt obligations. Determine how much you can comfortably allocate towards a down payment, closing costs, and ongoing fees related to the property. This will give you an idea of what you can reasonably afford. Just remember to have an action plan should your financial situation change unexpectedly.
Then, define your investment objectives and determine what you hope to achieve with your first investment property. What metrics do you realistically want to see? How do you plan to scale your portfolio over time? Setting clear goals will guide your financial preparations.
Step 3: Build a realistic budget
Create a comprehensive budget that considers all the costs of purchasing and owning an investment property. Consider one-time costs such as down payment, closing costs, inspections, and repairs, as well as recurring expenses like property taxes, insurance, maintenance, property management fees, and potential vacancies. Ensure your budget covers both expected and unexpected expenses.
Remember: Owning an SFR isn’t just about the rental income. Cash flow is a big benefit, but you’re also getting an inflation-resistant and appreciating asset. And that asset also comes with tax advantages!
Step 4: Save for a significant down payment
Start saving for your down payment, which is typically higher for an investor than an average buyer. The exact amount required will depend on the property type, location, and financing options. Aim to save enough to secure a favorable monthly payment and avoid the added cost of private mortgage insurance (PMI). A larger payment upfront will reduce your monthly debt liability.
Step 5: Focus on improving your credit score
A good credit score is crucial for obtaining favorable financing terms. Lending standards are higher than ever, so be diligent on this point! Review your credit report, address any errors, and take steps to improve your score. Pay bills on time, reduce bad debt, and keep credit card balances low to demonstrate your trustworthiness to lenders.
Step 6: Research financing options
Explore different financing options available to you, such as conventional mortgages, Federal Housing Administration (FHA) loans, or financing programs specifically designed for investment properties. Research lenders and compare their interest rates. It also helps to secure a lender that frequently deals with investors. For our part at REI Nation, we have preferred lenders that we will always recommend to our investors!
Step 7: Establish an emergency fund
As a property owner, having an emergency fund to handle unexpected expenses, vacancies, and turnover is essential. Aim to save three to six months’ worth of costs to provide a safety net. This will help you cover the unexpected without missing a beat. With your first property, this is particularly important as you won’t have other streams of income from other properties to pick up the slack!
As you diversify your portfolio, the additional cash flow will help ease the impact of these setbacks.
As you prepare to buy your first investment property, know that you don’t need to do it alone!