Saving For Your First Rental Property
So lets assume you’ve done all your homework, and you’re convinced the landlord business is a good fit for you. There’s plenty of ways you can get into the game without derailing your plans for Financial Freedom. I’ll highlight a few here, but first, some additional considerations worth making.
When looking at any first real estate investment, start small! Keep your budget well within your comfort level. Just because it’s an investment doesn’t mean you should ignore the FI rule of living below your means. No matter the market you live in, there is ALWAYS a possibility that your rental may run vacant, so vacancy should be an expense that you factor into your overall budget.
But starting small shouldnt just be about your budget. When deciding what type of property to invest in, don’t forget to consider the future cost of repairs/updates. It’s a lot cheaper to update or repair a small 800 sqft condo or 1100 sqft house than it is to renovate a 3000+ sqft property. Same rule applies when it comes to the size of land your rental is sitting on.
And don’t exceed your knowledge base unless you are prepared to do some quick learning. IE: If you don’t know anything about pools, or pool maintenance, and your brother-in-law or BFF doesn’t run a pool maintenance company, then having a first rental house with a pool probably isn’t the best choice.
So how exactly to approach saving for the downpayment of a rental property while still working towards your goal of financial freedom? Firstly, investing in real estate should work to further your goal of FF, so ideally once you’ve made your initial investment (downpayment), moving forward you should be receiving additional cash flow from the property (over and above all of the expenses) that you wouldn’t otherwise have had.
More income equals more savings, which equals a faster path to FF. It’s not an either/or situation, its both.
1 – The Piggy Bank Method
Start putting those nickles in your piggy bank and plain old save up for the downpayment. Nothing earth shattering here. But I like this approach because it requires a lot of self-discipline, control over your spending, and a strong focus on your goal. It also requires TIME (to save up all that money) which means you also have time to study your market, make contacts, and familiarize yourself with the laws governing landlord/tenancy obligations in your area.
People who are able to delay their purchases, and employ the self-discipline to save for what they want are generally the people who will find the most success in obtaining Financial Freedom
Additionally, a downpayment for a rental property is a much smaller, shorter term goal than simply saving for FF, and more often than not people perform much better when trying to achieve short term goals than the do the long term ones. In this case though, you are actually killing two birds with one stone. Saving the money for the immediate goal of a down payment, while at the same time creating an additional income stream for your future goal of Financial Freedom.
2 – The Reverse Approach
This is my favourite approach for a large number of reasons. If you already own your home, rather than saving up your money for a downpayment on a rental property, save up the money for a downpayment on YOUR next home. Whether it’s an upgrade or a downsize, start thinking about what type of home you could move to that would work best for your future Financially Free self. Or, if you have a long way to go before you reach FF, consider a move that speeds up your plan to get there.
When most people are looking to move, they almost always need to sell their existing home in order to access the available equity to make the downpayment for the next purchase. But what if you saved up the downpayment for your next purchase and didn’t need to access any of the equity available? Then you wouldn’t need to sell the home, and you could consider simply keeping it and renting it out.
There’s a number of upsides to this approach. One, the same pro’s from the conventional approach exist here. In order to save up a downpayment you need to employ that strong self-discipline, focus, patience and control over your spending.
BUT, depending on the mortgage requirements in your area, you may need a much smaller downpayment to buy your next property if you are purchasing it as a primary residence vs. investment property. Here in Canada, if you want to buy a residential property as your primary residence (depending on the price point) you would require only a 5% downpayment. But if you want to purchase it as a secondary or rental property, that downpayment requirement increases to a minimum 20%. That’s a big difference in terms of the amount and time frame to save up that downpayment.
On top of that, you also get the benefit of the time in which you’ve been living in your home comparative to current rental rates. You likely bought your existing property at least a couple years previously, and if you live in a rising market, it is very likely that rental prices have increased over the time frame you have lived in your home. That means you will be paying a mortgage amount equivalent to market prices 2+ years prior, while charging current rental rates. All of which should equate to additional cash flow in your pocket.
If you are someone who doesn’t mind moving every couple years, this is an excellent approach that can produce significant financial gains. If you do plan to use this approach, definitely consider having your home appraised PRIOR to renting it out. Depending on your area, capital gains taxes generally come into effect once the property becomes an income property. Therefore any equity gained during the time frame when it was your primary residence should be exempt from those taxes, so long as you can establish the market value of the home at the time it became an income property. (As always, make sure you check the tax laws in your specific area to ensure you are planning efficiently and in compliance with your particular countries/state tax law.)
3 – The Equity Withdrawal
I am not a huge fan of this approach, but as everyone’s financial situation is different, I will mention it here for consideration.
If you have been living in your existing home for sometime and paid down your mortgage significantly OR the market in your neighbourhood has risen substantially, you may very well have access to a substantial amount of equity in your primary residence.
Generally financial institutions will allow you to borrow upto 80% of the current value of your home, so you could consider refinancing or securing a Home Equity Line of Credit (HELOC) in order to gain access to the equity and utilize it as a downpayment for your investment property.
Important to consider that you will then be financing 100% of the investment property you are purchasing, and the entirety of your debt servicing costs (not just the mortgage for the rental, but also the debt servicing for the downpayment) should be considered when calculating your actual expenses comparative to the prospective rental income.
If you are anywhere near paying off your mortgage (within 5 years or less) I would not recommend this approach. You would be better served eliminating that debt and then looking at investment properties. BUT, if paying off your mortgage isn’t in the cards anytime soon, then this may be a good option because the cash flow you generate from your rental income could not only pay back the borrowed amount, but overtime, it could also allow you to contribute additional payments to your mortgage. Allowing you to pay it off faster than if you hadn’t bought the rental property at all. (Important to do the math on the time frame for your ROI, and how much additional time you will collect the rental income comparative to when you would have originally paid off your mortgage).
I quite prefer this approach if the equity you are accessing comes from an existing rental property, rather than your primary residence. Essentially this approach eliminates the need to continuously save down payments if you want to acquire multiple properties. You simply wait long enough for sufficient equity to have built in your existing rental (either though market gains or your rental payments paying off the mortgage) then leverage that equity to buy a second rental. Repeat that cycle a few times and you could be well on your way to some substantial real estate holdings, all without having to divert anymore of your savings to down payments.
4 – Alternative Financing
There are many very creative ways to obtain financing in order to purchase rental properties. Many are outlined in a variety of get rich quick books, and online sources.
But they all come with substantial risks, inflated interest rates, and for a newbie in the game of real estate, they are a great way to lose your shirt. While some of you may have read this post to learn about ways to do exactly that, here’s what I have to say about it. Don’t do it.
If you aren’t in a position to save at least the majority of your first downpayment for an investment property, you shouldn’t be looking at taking on additional debt, particularly not high interest/high risk debt. That is exactly how you WILL derail your plans for Financial Freedom.
The better approach is to keep it simple, save your money, and buy within your means. It might be a slower path to Financial Freedom than the get rich quick books “promise”, but the odds are much higher that you will only have to walk that path once. Try for the get rich quick approaches, and who knows how many times you will be starting back at zero.
If you’re struggling to save, go back to the basics, sort out the foundation of your finances, establish your savings, and once everything else is in order, then come back to investing in real estate.