How to buy an investment property

Purchasing investment property can be a great way to generate income and diversify your portfolio. Before making your first purchase, you should understand the basics of this kind of investing, including the different types of investment property, regional differences and the challenges of property investing.

And while doing your research is always critical for any type of investment, it’s especially important to consider the economic environment before investing in property. Interest rates, inflation and market volatility are all factors that can affect your decision.

Types of investment property

There are two main types of investment property: residential and commercial.

• Residential includes single-family homes, multi-unit properties like apartment buildings and duplexes, and short-term vacation rentals.
• Commercial includes retail, office and industrial property and other, more nuanced categories.

“Every property and property type will have unique characteristics that provide insights into their potential investment performance,” says Bill Merz, senior vice president and head of capital markets research at U.S. Bank. “Buying an investment property often necessitates detailed due diligence on expected rents, expenses and potential surprises to either.”

Jenny Yuen, mortgage sales supervisor at U.S. Bank, notes that she hasn’t seen property investors generate big profits since 2021 due to rising interest rates. “The math just doesn’t work with interest rates where they are now, unless you’re making a substantial down payment,” she says. “Putting 20% or 30% down often just isn’t enough in this environment.”

How to find investment properties

Once you decide which type of investment property to buy, the next step is to start looking for the right property. It’s often smart to enlist the services of a real estate agent who specializes in purchasing investment property. They will bring specialized knowledge and experience that can help you pinpoint property that offers the highest return potential and the lowest potential risk.

• Multiple listing services (MLS) are good places to look for a potential residential investment property. Your real estate agent can help you identify the best MLS based on the type of property you’re looking to buy and the geographic area you’re focusing on.
• Foreclosure/HUD homes are another potential source of residential investment property. A HUD (which stands for U.S. Department of Housing and Urban Development) home is a foreclosed property that is up for resale by the HUD. These homes aren’t listed on MLS. Instead, they’re listed at HUDHomestore.com, where you can search for properties in the area you’re focusing on.

Importance of cash flow and risk tolerance when investing in property

Whatever the economic factors, Merz and Yuen both stress the importance of cash flow when investing in residential and commercial property.

“Cash flow represents one of the most important drivers of investment performance,” says Merz. Inputs to consider include the amount of rental income a property is likely to generate and the likelihood and timing of receiving this income.

“Property investing is all about cash flow and risk tolerance,” Yuen notes. “It’s easier to be successful if you have ample disposable income, but it’s harder if you’re not financially stable. That’s why it’s important to seek advice from financial professionals and other experts you trust, not just a realtor, before buying property.”

Merz agrees. “You need to consider whether you have the necessary liquidity to cover expenses if a residential tenant vacates or a commercial tenant goes out of business or defaults,” he says.

This is especially important in an uncertain economic environment or a recession. “Think about how difficult it may be to find a new tenant in these circumstances,” he adds. “This doesn’t mean an empty building or default event makes a property a poor investment, but it does introduce uncertainty and raises the odds of a period of negative cash flow the investor must work through.”

Steps to take when buying investment property

Here are four steps to take when investing in property:

1. Obtain mortgage preapproval. “Work with your lender and other advisors to get preapproved for a mortgage and figure out your bottom line before making an offer on an investment property,” says Yuen. “The lender is going to need to know where your down payment is coming from, so be prepared to demonstrate this.”
2. Crunch the numbers. Yuen says you need to determine if an investment property will “carry itself” based on the rent and anticipated expenses. “In other words, will the rent charged be enough to cover the monthly mortgage and other expenses after it’s occupied?” she says, adding that vacancy rates shouldn’t exceed 25% in a fiscal year.
3. Consider all the costs. According to Merz, many first-time investment property buyers overlook certain costs that come with owning and operating a property. “Insurance, property taxes, ongoing maintenance and upkeep, and periodic major expenses (such as a new roof and mechanicals) are all a normal part of operating a building and must be included in cost assumptions,” he says. “Things like lawn service and snow removal may seem trivial, but they can absorb rental income quickly for some smaller rental properties.”
4. Scrutinize tenant quality. This can be a big unknown, especially when investing in residential property. “Renters are a big risk, because you never know who you’re going to get,” says Yuen. “It’s critical to perform background checks on renters before leasing to them to help prevent losses.”
5. Understand your legal obligations as a landlord. Renters have a number of legal rights guaranteed by federal and state governments. These include the right to fair housing, which guarantees that tenants cannot be denied housing based on race, religion, sex, age, nationality, family status or physical disability. Renters also have rights surrounding security deposits and the right to a habitable home that poses no threat to their physical health.

Benefits of buying investment property

There’s no question that investing in residential or commercial property can yield big benefits in the right circumstances. Income generation, along with potentially compelling returns, is one of the biggest draws, assuming the property maintains cash flow.

“Certain tax benefits may be available depending on the property and the investor’s tax situation,” says Merz. “Depreciation represents a non-cash expense that can reduce taxable income, which can lower taxes on every dollar of cash flow.”

Merz stresses the adage that three of the most important factors in real estate investing are location, location and location.

“Identical properties in different locations may have vastly different economics,” he says. “For example, compare a strip mall in a bustling high-income suburb with high traffic counts to the same building in a rural location. The tenant mix and quality, vacancy rate and cash flow will likely be quite different, suggesting the purchase price of the two otherwise-identical properties should be quite different.”

It's also important to realistically gauge how much time you’ll have to spend managing the property before investing.

“Some properties can be self-managed with a minimal time commitment, while others necessitate professional property management,” says Merz. “Property management can represent a material cost or material time spend if it’s self-managed, which must be factored into the financial projections of any property investment. Many properties require professional management.”

Should you buy an investment property?

When you’re considering how to buy an investment property, Yuen stresses that every investor and property is different.

“At the end of the day, it comes down to personal preference,” she says. “Make sure you understand the potential benefits and risks and that you’re comfortable with them. Also seek advice from professionals you trust, including your accountant, banker and financial advisor. They can help you make the right decision.”

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