Rental properties have long been considered one of the best instruments for creating generational wealth. In fact, there are more people who attributed their financial freedom to property investing than any other investment type over the last two centuries.
However, many investors do not build their portfolios big enough to create substantial cash flow. Individual property investors only average 3 rental properties, 38% of them keep their properties just because family won’t allow them to sell.
Undoubtedly, building a rental property portfolio merits plenty of benefits since the number of renters is still increasing. But how do you build a rental portfolio from scratch? In this article, we’re going to walk through buying your first property to growing it. We’ll also talk about managing your rental portfolio and the types of property you can invest in.
How to start your rental portfolio
Determine the objectives and goals of your portfolio
Like any other investment, building a rental portfolio must begin with the end in mind. Thus, setting up the goals and objectives of your investment portfolio will lay the foundation of how you invest.
- How much would I like to earn from this portfolio?
- How long is my timetable for achieving these goals?
- Will I treat this as a passive income or will this be my full-time job?
- If a financial emergency were to arise, would I be able to weather the storm without selling, or would I have to sell?
- How much time am I willing to spend looking for the right home(s) and managing this portfolio?
Understand your financing options
Other than the types of rental properties you can invest in, how you finance those investments can also have a huge impact on the risk and return of those investments. Each type of financing has its own pros and cons.
- Paying with your own cash – Paying cash upfront is the most conservative way of investing in real estate. Plus, it allows you to get deals quicker since it removes the financing doubts in the seller’s mind. However, cash payments put a limit on the ROI of your investment. They also slow down the growth of your portfolio since you will be tying too much capital in one asset class.
- Conventional financing – Banks offer the lowest interest rates, therefore, giving you the maximum ROI potential. However, getting approved for loans is typically harder and they do require a 20 to 25% downpayment. This option may not be available for investors with a bad credit score and no cash.
- Private lender – Private lenders are individuals or businesses outside of the financial institution. Unlike conventional banks, they are more flexible and approve faster but they also have higher interest rates. This is a viable option for investors who can’t get financing from banks.
Your ability to identify good properties from bad ones can help determine how successful your portfolio will be. Most property investors follow the 1% rule which states that your property should be able to rent for at least 1% of the total value of your home.
However, there are other things that you need to consider when evaluating properties such as the general vacancy rate within the neighborhood and the growth potential of the area. Evaluating properties is a skill every aspiring investor should master.
Growing your rental portfolio
Buying your first property, finding your first renter, and managing your property will teach you a lot of things about rental property investing. You’ll find out how real estate deals go and you will be better equipped to anticipate potential problems for your next deal. The next challenge is to grow your rental portfolio.
Use your current assets to acquire new properties
After your first real estate purchase, you open up better access to financing thanks to your acquired asset. There are three common ways property investors use their existing assets to expand their rental portfolios:
- Cash-out refinancing – this involves replacing your current loan with a bigger one and getting access to cash amounting to the difference between your first loan and the new one. You can use the cash as a downpayment or buy another property outright.
- Home equity loan – this requires taking out a second loan amounting to 85% of the value of your current property as equity. Home equity loans give you access to bigger cash allowances and will help you to expand faster. However, this also means you need to pay off more loans, increasing your portfolio’s overall risk.
- Home equity line of credit – this is much like a credit card but tied to the value of your home. You can use this line of credit repeatedly and you will only have to pay off your debt if you borrow money. The downside of this method is that the interest rates fluctuate and tend to be higher.
Diversify your rental properties
Diversification is an investing strategy used to manage risk. This strategy is often applied in other investments such as stocks and bonds but is rarely talked about in real estate strategy because of the higher cost per investment ( it is harder to spread out your bets).
While it’s true that diversification in a rental property portfolio takes time, there are several ways to diversify, including
- buying properties in different locations
- investing in different types of properties (single-family, multifamily, commercial)
- using different ways to finance your properties
- buying properties in different price ranges
Diversification is also a hedge against uncertainties. For example, during a recession families tend to go for low-cost rentals, if your portfolio primarily comprises expensive homes, you may have trouble finding a renter.
Similarly, if the neighborhood where one of your properties is located suddenly becomes an unfavorable location, you still have properties in other locations to keep your cash flow.
Managing your rental properties
Owning a portfolio of rental properties isn’t as passive as other types of investments. You will need to market your properties, answer phone calls, collect rent and deal with maintenance. That’s why having a portfolio of rental properties can quickly turn into a full-time job.
Managing multiple rental properties yourself is rarely a viable option for homeowners. If you have the time, know-how, and contacts to trusted vendors, you can certainly save a few hundred bucks per month on property management costs.
However, managing rental properties by yourself also have hidden costs.
- Higher vacancy rates
- Marketing costs
- The value of your time spent managing your property.
- Higher turnover rates due to poor-quality tenants (resulting from a lack of a thorough screening process)
- Higher cost of vendors (some property management companies get discounts from vendors)
- Other costs such as gas, commuting, and bookkeeping
Thus, as your portfolio grows, consider hiring a property manager that can handle all your properties efficiently. Use an ROI calculator to find out how much you will save by hiring a property manager versus doing it yourself. That way, you have a solid basis for deciding whether or not a property manager is worth it.
Some property management companies, like Poplar Homes, use technology to streamline and automate the repetitive tasks of property management. Robust tech allows you to keep track of all the properties in your portfolio in a single dashboard giving you an instant big picture of your investments.
To that end, property management companies are a great way to delegate your tasks and have a clear view of your portfolio so you can just focus on growing it.
Types of rental properties you can invest in when building a rental portfolio
As the name suggests, this type of property caters to single families. It is typically a standalone structure that doesn’t share any common walls with other residences.
Single-family homes offer complete privacy and often have their own backyard, front yard, and garage. Out of all the property types, single-family homes are the easiest to own and manage, they also have a high occupancy rate. However, cash flow is highly impacted by vacancies.
To give you an idea of what that means for your portfolio, here’s a scenario:
If you have two single-family homes and one of them goes vacant, that’s an instant 50% drop in your revenue whereas if you have a 20-unit apartment building and you lost 2 renters, that’s only a 10% drop.
Small multifamily buildings
Duplexes, triplexes, and fourplexes are categorized as small multifamily buildings. Like a single-family property, they require less maintenance and involvement than an apartment building.
In this type of building, the dwellings are structurally connected but are separated by a wall. They also have their own living areas and amenities. Small multifamily properties are semi-private and cater to small families in the mid-income range.
Small multifamily buildings are the gateway to multifamily assets. For a cost slightly more expensive than a large single-family property, you can double, triple, or quadruple your revenue without acquiring multiple single-family properties.
Multifamily properties are buildings that cater to multiple renters. This can be in the form of an apartment building, a townhouse complex, or high-rise condominiums.
Generally, multifamily investments have a better, more stable cash flow. However, they require more maintenance. They also have a higher turnover rate and involve a larger operational cost.
Apartments typically cater to the workforce, students, and small families who are looking for cheaper housing. During an economic downturn, multifamily assets also fill faster compared to the average single-family rental.
Vacation rentals are short-term rentals that cater to travelers. They can be a multi-unit building within a famous tourist destination or a single building that offers exclusivity with beautiful amenities.
Vacation rentals have a very high turnover rate and operational costs. You also have to spend time and effort in marketing your property. The income generated from this type of rental is often seasonal and is subject to competition such that if a nearby vacation rental offers better amenities, you most likely have to upkeep and add more to your amenities in order to compete.
The plus side is that vacation rentals are more expensive to rent on a day-to-day basis, therefore, can bring in more cash for the larger headache.
Commercial properties are ones that cater to businesses. Out of all types of rental investments, commercial properties have the longest lease agreement, therefore, offer stability in cash flow. Your renters also have a vested interest to maintain their own storefront and place of business.
The commercial property market, however, is currently in turmoil following the COVID-19 outbreak. Commercial property companies report having high numbers of unused office spaces and are having a difficult time finding new renters. Hence, many investors consider these assets risky at the moment.
Additionally, commercial properties have a steep upfront cost since these types of buildings are located in prime real estate locations. They also have a high operational cost for the maintenance and security of the common areas.
What this does for your portfolio is create stability. For example, if you own a commercial building with 10 renters who signed a 5-year lease, you’ll have your living expense covered over that 5-year period while you continue to build your rental portfolio.
Real Estate Investment Trusts (REITs)
These are investment vehicles that allow you to invest in an entity that operates a rental business and is traded as Exchange Traded Funds (ETFs). By law, they are required to pay out at least 90% of the company’s rental income to investors.
REITs give you a steady flow of income like a typical rental property with the added benefits of low upfront cost and zero involvement in the operation. This makes REITs the most passive type of rental property investing there is.
REITs also provide liquidity for your portfolio. Since they are traded like ETFs, you can sell them almost instantly to cover your expenses in case of an emergency.
The downside of REITs is that they can’t be used as leverage in acquiring new properties, hence, it takes a longer time for investors to grow if they invest solely in REITs. You also have no control over the outcome of the properties you invested in.
3 Tips for building your rental portfolio
Once you’ve set your objectives for your investment goals, the next step is to buy your first property. There are plenty of things that could go wrong with your first purchase, so we recommend that you start small with your first few purchases.
Smaller single-family homes require less work compared to multifamily properties and are generally easier to acquire.
Also, don’t buy the grandest single-family property available on the market. Your aim should be to learn as much as you can from this transaction and get a sense of what it’s like to be a rental property owner. Most property investors even start out by renting out their old residence which is generally safer than buying a house for investment.
Invest locally first
Single-family homes in a neighborhood you know are usually the best option to start with. Before you think about investing in popular big cities or major tourist destinations, invest in your own neighborhood first. This allows you to evaluate the property and better understand the local challenges within the area. You also most likely already have access to vendors and service providers you trust. If problems were to arise, it’s easier to handle them yourself if you live within the area.
One of the reasons why real estate is preached by successful people is its ability to be used as leverage to grow rental portfolios exponentially. Hence, you should take advantage of this fact and acquire more income-producing properties as your portfolio gets bigger.
For example, if you bought a single-family home for $100,000 which you rehabilitated and rented out for a year, you can refinance that property and use the cash to acquire bigger properties (or more properties) rather than buying one property of the same kind and price range. Then, repeat the process and buy even bigger properties (maybe an apartment building with more units).
This wealth-building strategy is called “the stack”. The idea is to grow your portfolio exponentially by buying more or bigger properties rather than adding one property to your portfolio each time.
Building a rental portfolio is an ongoing process that will require time and effort. There are several types of rental properties to invest in, each offering different benefits.
When growing your portfolio, take advantage of the different financing options by using your current properties as leverage. This will allow you to grow exponentially, building wealth faster. You must also diversify your portfolio by investing in different asset types and classes, locations, and price ranges. This ensures that you will hedge your bets against uncertainties such as recessions or any localized situations in a given neighborhood.
Lastly, hiring a property manager who can run your property well while you continue to find and evaluate deals is paramount to the growth of any successful portfolio.
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