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Are you looking to invest in a rental property but aren’t sure what the telltale signs of a good investment are? In this article, I’ll share five tips for how to evaluate whether a property is worth your time and money and what to look for in an investment property.
From market research and risk analysis to comparing local rentals and calculating your Net Operating Income (NOI), this guide equips you with the knowledge to evaluate your next investment wisely.
Related: 3 Things to Consider Before Buying an Investment Property
1. Do thorough market research
It’s vitally important that you conduct thorough research on your new property before taking action. Real estate investments can be lucrative, but they can also be a money pit without proper planning and preparation. That’s why the first step in how to evaluate an investment is to take the time to figure out exactly what goals and ideas you have for the property.
You should have an idea as to whether you would like to rent the house out long-term or have a series of short-term renters. Long-term tenants serve as a consistent income stream, and you don’t have to dedicate as much time or effort into finding tenants to fill vacancies as often. However, short-term tenants allow you to raise rent prices between periodic leases, plus you have the opportunity to remove tenants who you’d rather not rent to again, even if you don’t have proper grounds (or funds) for eviction.
You should also start investigating the market you’d like to invest in. There are many factors that influence how appealing a particular area will be to renters — for instance, an influx of new construction might lessen the demand for your rental, while attractive amenities, restaurants or school systems in the local area could increase the demand for and value of your property.
It’s also important to realize the potential costs that come with a new rental. Do you want to offer a furnished unit? The cost of furniture and cleaning associated with a furnished unit can add up. You’ll want to consider these costs plus appraisal fees, inspections and other fees that can put a dent in your capital.
2. Conduct a risk analysis
Building on the last tip, conducting a risk analysis is a great way to plan for potential risks and be better prepared for hiccups when they happen. The real estate industry is known for being volatile, so to best protect your investment, expect changes in the following factors:
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Essential service prices, like gas and electricity
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Local employment rates
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Property taxes
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State and local laws
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Quality of applicants
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Government real estate policies
A good way to quantify the level of risk for each factor is to assign each one a score of, for example, one to five — five being the highest level of risk. If a property has a higher risk factor score, be aware that it could potentially lead you to spending more money than you’re comfortable with.
Related: How to Get the Most Out of Your Rental Property Investments
3. Use comparable rentals in the area
An important step in evaluating your new rental property is to see how it stacks up against the other properties in your local market. In doing so, you can keep your expectations on expected cash flow in check.
Conduct a sales comparison by finding properties that are similar to yours and calculating the price per square foot that they sold for. Be sure to look at properties that have been sold within the last month so that your numbers are as accurate to the state of the current market as possible. When looking for comparable properties, try to find units that have approximately the same number of bedrooms and quality of amenities as yours.
Additionally, consider whether the location that you’re researching is the right location for the type of renter you’re looking to attract. For instance, if you’re primarily targeting local families for your rental, you’ll want to evaluate whether the school system nearby is high quality. If you’re targeting young professionals, however, you might investigate whether the property is close to public transit. An excellent location can upgrade a mediocre property to an extremely desirable one, so don’t overlook this step when choosing where to invest.
4. Calculate your NOI
Your property’s NOI (Net Operating Income) is the total amount of income that it will generate, minus general operating expenses. It is calculated by taking your total rental revenue over a certain period of time and subtracting all regular operating expenses required to maintain the property over that period, such as the cost of repairs, property management fees, insurance, property taxes, etc.
If you divide your NOI by the original price you paid for that rental property, you get the capitalization rate, which measures how long it will take for you to make back your initial investment. If you have a high cap rate, you have more revenue and a strong overall investment.
However, it’s important to remember the few factors that could skew your cap rate calculation. When you use cap rate to evaluate a property prior to purchasing it, you’ll need to estimate the potential rental rate and total expected income. That means that you’ll have to find the cap rate after you research what similar properties are charging in your area. Also, if you intend to flip a low-value home, your cap rate will not include the cost of renovations or the fact that you will not be renting the space out and are selling it instead.
Related: How to Start Investing in Rental Properties — Your Step-by-Step Guide
5. Consult a professional
As an investor, you need to understand how a property’s current state will influence what it could be valued at in the future and how much you can profit from it at the time of sale. One of the ways to do this is to hire experts who are experienced in this field to give you an estimate.
A professional property valuation estimates how much capital you’ll need to maintain a property. Maintenance costs are a significant factor in determining your overall profit from a rental property. A property valuation will take stock of larger assets like the roof, insulation or HVAC system to see what condition they’re in and how much you may have to spend to keep them functioning. You can also request a formal appraisal to have a professional estimate of the true value of the property based on factors like location, demand and lot size.
The key to a great investment is solid upfront research. Real estate is a great way to be your own boss and possibly achieve streams of passive income — but first, you must dedicate significant time and effort to ensure your venture is a good one. Hopefully, the investment property tips above help you find a quality investment.
