Real estate is one of the best investments that stand the test of time but how do you know if a rental property is a good investment or not.
There are tons of ways to make money with real estate. One of them is to find a profitable rental property that will yield consistent income.
Taking the time to determine if a property is a good investment is an essential step before getting involved in a real estate deal. As not all real estate investors are created equal, you first have to discover your unique goals.
Before investing in a property, you want to make sure it commands the price within your range and it projects to generate returns that meet your cash flow quota.
A huge part of the success of a real estate investment deal is researching the property extensively to determine if it will produce the returns needed.
Investing in real estate is an art that should be carefully practiced. There is no need to rush out to buy the next seemingly good deal. Extensive due diligence before a purchase allows you to carry out a more deliberate approach when it comes to selecting your real estate investments.
Let’s dive right in and see what it takes to determine if a rental property is a good investment.
How To Know if a Rental Property is a Good Investment
Determining Your Investment Criteria
The first step as a real estate investor is to know your goals and abilities. Where do you see yourself in the next five years? What are your current abilities to invest?
Perhaps you see yourself earning $7,000 per month on passive income from one property. If you have that type of goal, you’ll have to select a property that can deliver those results.
You will have to look into specific areas and types of properties that reach the monetary goals you’re looking to achieve. For instance, many investors have great success with single-family home rentals while others thrive on dealing only with multifamily units.
Factors to Consider
A systematical approach is required when analyzing a property. After considering several factors and breaking down all the numbers, you’ll be able to determine if a particular property works for you.
Aside from the positive factors that draw you to this property, as an investor, it all comes down to the final figures. It is important to stick to what the cash flow analysis equations indicate and allow the numbers to speak for themselves.
The following are points to consider when selecting a property:
- Choose single-family homes if possible
- Buy only well-maintained and updated properties, no fixer uppers
- Location should be within metro area with over 1 million people
- Property is near job opportunities and desirable area
- Price must be within the median range in the area
- Properties must be priced between $100K and $200K
Using the One Percent Rule
The one percent rule is a tool that real estate investors use to determine their best options with a quick and efficient rule of thumb. This rule can quickly help an investor determine if the property is worth further research.
The one-percent rule states that the investment property must rent for one-percent or greater than the total upfront costs it required from the investor.
The following are examples to help you further understand this rule:
- Properties that costs $100,000 must rent for a minimum of $1,000 monthly
- Properties that costs $200,000 must rent for a minimum of $2,000 monthly
- Properties that costs $300,000 must rent for a minimum of $3,000 monthly
The investor has to remember to add the total upfront costs to acquire the property, meaning the purchase price including closing costs, plus the costs to make necessary repairs to put it up for rent.
This means that if the investor acquires a property for $200,000 and it needs $50,000 in repairs to make it rentable, the property must rent for at least $2,500 per month to make the investment worth it.
When the investor is certain that the property passes the one-percent rule, then it is worth looking deeper into it. However, if the property doesn’t pass this initial test, it is certainly not worth investing more time into it.
Know the Market
One of the most efficient ways to determine a profitable rental price is to see how much rents are going for in your area. Websites such as Trulia and Zillow provide reliable platforms for research.
Staying competitive in the market will be a sure way to thrive in this business. The rental market is flooded with options. Savvy consumers are now exploring all of their options before settling into a deal too quickly.
The more you’re able to offer at reasonable prices, the more you’ll stay competitive in a fast-paced market. When you know what your customers need, you’ll be able to adapt your offer to stay competitive.
Metrics Needed to Determine if a Rental Property is a Good investment
1. How to Calculate Your Return on Investment
The ROI calculations must be accurate to determine the true profitability and efficiency of the real estate deal.
To calculate the ROI, you simply take the annual pre-tax profit (income minus expenses) and divide it by the total cost of the rental property (purchase price + closing costs + remodeling costs). Most investors consider a minimum of 15% ROI a good return on investment.
Rental Property Return On Investment Calculator
Although it is always a good idea to understand the formula behind the metrics we need for profitable real estate investing. My rental property ROI calculator below will help you work out the accurate return on investment for your existing property or a new potential deal.
You can either enter data in all of the boxes or just the Purchase Price, Total Annual Revenue and Total Annual Expenses fields.
2. Calculating the Capitalization Rate
The cap rate or capitalization rate provides insight into the rate of return on a particular income property based on the NOI (net operating income). Taking the method of financing into account, the cap rate allows the investor to determine the rate of return considering the financing option.
An acceptable cap rate is generally between 8 and 10 percent. The cap rate is determined by taking the net operating income and dividing it by the price of the property.
3. Cash on Cash Return
A CoC or cash on cash return provides a measurement of the return on investment each year based on the total cash invested. It is a measurement that fluctuates according to the various financing methods utilized.
Acceptable cash on cash return is approximately 8 percent, but investors should aim for reaching 10 or 12 percent. The cash on cash return is measured by taking the annual pre-tax cash flow (income minus expenses) and dividing it by the total cash invested (down payment, closing fees, remodeling costs).
4. Determine all of Your Upfront Costs
Before choosing an investment property, it is key that you accurately calculate the running costs and projected expenses necessary to make the deal a reality.
As you calculate your final figure, be sure to add 10% to cover unexpected increases in costs such as taxes or costly repairs.
This cushion will help you deal with unexpected obstacles that may arise with insurance, utilities, vacancies, and other setbacks frequently encountered by property owners.
In addition to calculating property expenses, the investor has to set money aside to cover legal fees, accounting, property management, and operating costs.
Knowing exactly how much it takes to carry out a successful rental property can create a much easier experience as there are already enough unknowns when it comes to investing in rental properties.
5. Planning for Property Management
Besides knowing the financial side of an investment deal, an investor must know a thing or two about managing the property. Many investors opt for outsourcing a property manager who will take care of the property from beginning to end.
Property management companies provide investors turn-key operations. Real estate owners can have peace of mind knowing that they will receive rental income with minimal effort on their part.
Enlisting the services of a professional property management service is key is keeping up with the day-to-day responsibilities a rental property requires.
This type of service is especially important when the investor owns more than one property.
Working with a property management company is also a great way to manage out-of-town properties. Being a landlord is a very “hands-on” job that requires a lot of time and attention.
Part of determining if a real estate investment makes sense to you is knowing what it takes to operate and maintain it.
My Final Thoughts on Determining if a Rental Property is a Good Investment
Different from the stock market and other types of investments, the real estate market is much easier to predict if you are an informed investor. You must pay attention to market changes to stay on top of the market cycles in your region.
It is as simple as researching online to get familiar with crime rates, rental rates, school ratings, real estate rates, population shifts, local employers, and other determinants.
The key is to spot up-and-coming neighborhoods that are on the rise.
As soon as you realize that your investment property is in an area that has taken a downward spin, you may opt for selling it before letting the property values plummet.
You must get familiar with the market and get out ahead of market shifts.
Taking the time to do the necessary research can make the difference between staying in business or leaving the real estate investing game.
I would love to hear your views now please.
I would love to hear your comments and have you share with me how your rental property is a good investment.
Thank you very much and have a great day.