How do I determine a good rental property is a good investment? This is a question many investors ask themselves time and again.
Getting answers to this question may just be your turning point at differentiating a good investment from a not-so-good investment.
There are quite a several factors that determine whether an investment is good or not. We shall learn what factors to look out for, both from the physical sense and the numbers.
This is perhaps the most important factor that investors cannot afford to overlook. The neighborhood in which an investor decides to invest plays an integral role in the performance of the real property.
The location of the rental property will determine the quality of the potential renters. Besides, locational properties will also determine the property’s potential.
The reason why location is considered one of the most important factors is that you can always change the features of the home such as the floor area, the roofing structure, and the quality of the finishes, but you cannot change the location of the property.
Therefore, before you consider anything else, first thoroughly analyze the neighborhood in which the property is located. This calls for due diligence. Research the neighborhood in which you are planning to invest. Analyze the socioeconomic indicators.
Look out for factors such as the crime rate, the average number of home sales per annum, the medium household income, the presence of public transport, proximity to good schools, the unemployment rate, and the demographic trends.
As a general rule of thumb, the nearer your property is to other facilities, the higher its desirability, and the higher the amount of rent you will be able to charge.
2. The Local Economic Market
Getting an idea about the local economic trends can give you an idea of how your rental property is likely to perform in that market. Check if new developments are coming up in the area, both ongoing projects and those that are in the planning phase.
The presence of new developments indicates that the area is desirable. It also means your property will be near new and probably high-quality facilities; that is an indication of growth.
Visit the local government’s website to find out if any revitalization projects are being undertaken in the area. Are there public utility systems that are being added?
The presence of companies is also a good economic indicator. Are there new companies that are moving to the area? What is the rate of unemployment? How good is the job market?
If the rate of unemployment is relatively low, and the job market good, the demand for housing will increase hence driving up the rent payable for your rental property. So if the local economy is performing well, your investment property is also likely to follow suit.
3. The Local Real Estate Market
After checking out the local economic market trends, you need to go more specifically into the local real estate market trends. Get to know how real property investments perform in the market.
What are the property occupancy rates in the general neighborhood? Places with high occupancy rates are good for investment. That means they will have low vacancy rates.
Low vacancy rates mean there is a high demand for rental properties in that area. You will not have long periods of vacancy when you will not be earning rental income.
Remember, during this period of vacancy, you will still be paying property taxes, and probably servicing your mortgage. High tenant occupancy rates will also mean that the rental properties are on-demand hence you can charge higher rent.
4. Property Taxes
The investor must take the step to learn and understand the area’s property taxes. Property taxes vary from one neighborhood to another. The amount of tax payable may even vary within the same neighborhood.
Get to know how much you will be expected to pay in taxes before acquiring the rental property. Property taxes are part of the outgoings of a real estate investment.
Therefore, computing them means you will be able to project your returns with greater accuracy. It is not automatically wise to run away from high property taxes.
If the property is located in a good neighborhood that is likely to attract quality tenants at high occupancy rates, you will be able to pay the taxes and still earn substantial net income.
Apart from the locational characteristics of a property, tenants often look out for the amenities that the specific rental property has to offer.
The physical features of the property pay a vital role in attracting tenants.
Look out for features such as the number of bedrooms in the home. Is there an outdoor space?
If the given neighborhood is known to house families with kids, a property with a yard would be a good fit for them. A family is also better housed in a home that has more than one bedroom and at least two bathrooms.
Is there a parking space for tenants who have a car?
The more amenities a property has, the more attractive it will be to renters, and the higher the amount of rent you can charge. So look out for amenities such as a gym, a swimming pool, and security systems.
6. The Monthly Expenses and Cash Flow
The monthly expenses play a vital role in determining how much you can earn from your rental income. Determining how much you will be earning from the investment will require you to come up with cash flow.
The property’s cash flow is the difference between the monthly rental income from the property and the monthly outgoing or expenses of the property.
A property’s cash flow can either be positive or negative. Positive cash flow means that you will receive more income generated from the property than the expenses.
On the other hand, a negative cash flow indicates that the expenses spent on the property are higher than the income generated by the property. The goal, therefore, should be to minimize the expenses as you maximize the income.
The investor must be able to identify every expense and quantify them. Some expenses could be one time while others may recur monthly. Consider all the holding costs of the property.
They include utility bills, property taxes, property management fees, mortgage repayment, among many other expenses. Compare the monthly holding costs to the expected monthly income from the property.
6. Repair and Maintenance
The cost of repair and maintenance can also be considered to be part of the expenses, but they are not incurred every month in most cases.
Therefore, besides the property management fees, property taxes, and all other expenses, an investor who is trying to determine the suitability of a property for investment must consider the repair and maintenance costs.
Once you hold rental property, you should expect to once in a while rehab it to maintain it in a suitable renting condition. The amount of money spent to do that must be put into consideration to determine whether the property is worth purchasing.
Once you have projected the expected cash flow, check if it is enough to cater for the repair and maintenance costs. If it exceeds it or leaves you with very little profits, then the property is not worth buying.
7. Local Regulations
Each neighborhood has its requirements from landlords and property owners. As an investor and a potential landlord, you need to check out all sorts of laws and Homeowners Association (HOA) codes that may directly influence your engagement as a landlord.
You would want to choose a rental property that is located in an area that has regulations that are landlord-friendly.
If you are interested in investing in multifamily housing units such as apartments, you would not want to invest in a place whose zoning regulations restrict residential units to two floors.
Make sure you invest in an area that has no rental restrictions that can jeopardize your ability to earn substantial rental income.
Watching out for these regulations and city council restrictions will enable you to avoid finding yourself on the wrong side of the law and paying huge fines. You want to be law-abiding but at the same time earning your income without disturbance.
8. Determine the Cap Rate
Also known as the capitalization rate, the cap rate is the rate of return on real property assuming the property was funded by 100% equity.
This assumption that the property is purchased using cash only gives room for one to focus on the property itself and its profitability without having to worry about the financing bit of the property.
The cap rate indicates how much an investor is likely to make or lose if they acquire the subject property. It is just an estimate, not an exact amount.
The ca rate is determined by dividing the property’s Net Operating Income (NOI) by its current market value, or its purchase price. The cap rate is used to measure the amount of risk inherent in a real estate investment.
A low cap rate indicates low risk and vice versa. Experts in the real estate industry recommend investors to invest in property with a cap rate of between 8% and 13%.
The understanding of risk in real estate investment is that a low-risk property potentially produces relatively lower returns compared to a high-risk property that has the potential to produce higher returns.
So all factors kept constant, a rental property with a higher cap rate is a better investment.
9. Compute the Cash On Cash Return
The CoC return measures the annual return on the investment you have made based on the NOI and the amount of cash that the investor has put in the investment. It is computed by dividing the NOI by the cash initially invested in the project.
You have to spend money to earn money, or so they say. The CoC, therefore, helps determine the amount of money you are earning back annually for pumping in a certain amount of money into an investment.
A good CoC return is one that is above 8%. Real estate professionals, however, advise that you aim for a cash on cash return above 10%.
Compared to other investment assets, real estate is easier to predict if you know exactly what to look for. Knowing the aspects to consider will put you several steps ahead when it comes to realizing success in your investment.
You will reduce your exposure to risk. Since investor needs vary from one investor to the other, you must determine factors that are most important to you.
Use the cash on cash return rate, for instance, if you are keen on putting into consideration your method of financing.
As you analyze the suitability of your rental property investment, make sure you look like the long-term implications of holding the property as opposed to short-term implications.