Things to Consider When Evaluating Rental Properties
When you are looking to buy a rental property, there are four considerations which can help you make the best choice. These following four factors can help you evaluate an investment:
- Current Market
Evaluate the Location of the Property
Location is one of the most important things to consider when evaluating a potential investment property. It can help you make an educated guess about the property’s potential to appreciate over the years.
For example, real estate guru Robert Kiyosaki talks about the benefits of buying an income property near a college community. The reasoning is, there is always an ample supply of tenants, the students' parents will usually pay the rent and you can often charge a higher rent because of the desirability of the area and increased demand for apartments.
What the Neighborhood Is Like
- Is it suburban or urban?
- Is it close to retail shops, transportation hubs, hospitals, and schools?
- What type of tenant will want to live there? (families, seniors, single people, middle class, etc.)
- Is there an ample supply of tenants in the area?
- Is it close to your current residence? If it is far away, you will have to factor in travel costs in terms of financial costs from commuting and opportunity costs from lost productivity.
- Is the neighborhood stable, expanding or in decline? Are there a lot of vacant properties or is there a lot of new construction?
- Do you see an opportunity for growth in the future? For example, a new railroad line that connects to a major city is being built, or a new company is relocating to the area and creating new jobs. These can dramatically increase the desirability of the location.
Evaluate the Property's Financials
Know Your Budget
- How much can you put into this investment?
- How much can you afford to lose?
- If you need additional funds, where will you get them from?
- What will your monthly mortgage payment and interest rate be?
Look at the Value of the Property
- Ask to see the actual income and expense sheets for the property. If none are available, make sure you are able to reasonably predict the operating costs.
- Calculate the Net Operating Income (NOI) for the property.
- What is the standard vacancy rate for your area?
- What is the projected rent for the property?
- What would insurance cost?
- How much are taxes?
- What will property maintenance cost?
- Have you determined your market’s Capitalization Rate (Cap Rate)? If you are unaware of your market’s Cap Rate, you should consult with a local real estate broker.
- Once you have determined the Cap Rate, you can now divide the NOI by the Cap Rate and get the current value of the property.
- Have you done a Comparative Market Analysis (CMA)?
- What are comparable homes in the area selling for? Whether you are buying a rental property or looking to flip a house, you will want to make sure you are not over-paying for the property.
Evaluate What Repairs Are Necessary
What Repairs are you Comfortable With?
- Do you want a property that just needs a coat of paint and new carpet, are you OK with a moderate amount of work or are you comfortable with a gut rehab (new plumbing, electric, floors, walls, etc.)
Can You Afford to Make These Repairs?
- The cost of repairs will vary greatly depending on if you are able to do it yourself or if you need to hire someone else to do it.
- Your construction budget for materials and craftsmanship will also vary widely depending on whether you are renovating a million dollar home or a fifty thousand dollar rental property.
- Another general rule of thumb is, repairs will always cost more than you have planned for. If you hire a contractor, a two-week job often turns into four weeks. Even if you are doing the repairs yourself, costs can get out of hand. For example, You plan to put up new drywall in a room for $800. When you open the walls, you find an infestation of termites and the need not only to exterminate but to also re-frame the walls. Unexpected expenses like these will add up quickly. You will not only be hit with a higher construction budget, but you will be paying additional financing costs, called "soft costs," to pay the mortgage, property taxes, and insurance on the vacant property while these additional repairs are completed.
Evaluate the Investment Compared to the Current Market
Trying to flip a McMansion during a recession will not be the easiest venture. In a recession, buying a foreclosed property to rent out to tenants might be a better bet for success. You need to look at what is trending in the real estate market now and adjust your plan accordingly.
If you buy that McMansion and have the money to hold it for seven years until you can sell it for a profit, then, yes, it can potentially be a good investment. Another thing to look at when buying a property is its resale value. Highly desirable assets are those that can be easily bought and sold regardless of the market. They are always in demand. Think of them as necessities, like bread and water.
People don’t need a house with an inground pool and TV screening room. People do need a house with a clean bathroom and a strong roof. You want your property to appeal to the greatest amount of people so you have the greatest number of prospective tenants and buyers.