Do you know what to look for when you start shopping for rental properties? How can you tell a good rental property from a bad one? What makes a rental property a good deal? How do you know you aren’t shooting yourself in the foot by buying a rental property that will never offer you a profit?
If you are newer to investing, you’re likely sitting in the dark about what to even consider as you shop for rental properties. You don’t know what you don’t know. How could you have known it if we were never taught it?
To help you get started, here are 5 vital considerations that you should have in your mind as you begin rental property shopping:
- The Numbers
Numbers matter in real estate investing, for the obvious reason of—they are the whole point of investing in the first place. We invest in real estate to make money, and money is formatted in numbers.
Where is your profit coming from on a rental property? Profit comes from the difference in income and expenses. What are those numbers?
Every month, a rental property will cost you money. Most months, you will receive income from the same rental property [hopefully]. Which is higher—the income or the expenses? This number is your cash flow. It will either be negative or positive each month.
Desirably your rental property will produce positive cash flow each month. Sometimes there are good reasons to buy a negative cash flow property, but regardless of whether you are shooting for positive cash flow or you’re okay with negative cash flow, you need to know what the projected cash flow is.
Once you know your cash flow (which you’ve calculated based on actual numbers and not your best guesses), you can start to calculate what kind of return on your money you’ll be looking at. The question is—
How much income will you receive in comparison with how much you invested?
You’ll often hear this described as your return on investment, otherwise called your ROI.
Rental properties are a little bit tricky because there are multiple ways you can make money on them: monthly cash flow, appreciation, tax benefits, equity build-up via mortgage pay down, and indirect profit via hedging against inflation. A perfect rental property will produce income from all five of these profit centers, but not all five are applicable on all properties or required in order to see a profit. What you should know before buying any rental property, or any investment property for that matter, is which profit centers you can reasonably expect to see income from. If you don’t know the answer to this yet, you aren’t ready to buy the property.
Your overall ROI will include all income from all of the applicable profit centers. This ROI though is extremely hard to calculate accurately, if not impossible, because not all of the numbers can be known. For instance, appreciation is speculative and isn’t guaranteed and tax benefit returns are very hard to calculate. For this reason of the unknowns, typically the “cash-on-cash return” is calculated just off of the monthly cash flow since that number is more known.
The cash-on-cash return can be calculated by dividing the annual net income (income after all expenses) by how much money you put into the deal. This will show you the percentage return you are getting on your money. This number can end up being positive or negative. If it’s negative, you may need to look for another property unless you have some grand plan for how to earn a profit on a negatively cash-flowing rental property.
At the end of the day, the price of the property will be the primary contributor to the numbers because this, combined with the condition of the property, will determine your expenses on the property.
- Numbers Sustainability
Not to make things more complicated, but the next question after you run the numbers is whether or not those projected numbers will ever see the light of day or not.
When you run numbers on a property, essentially they are only projected numbers until they are proven, and they can’t be proven until you’ve already bought the property. While this seems unfortunate, which it is, there are known factors that help contribute to the feasibility of the projected numbers becoming actual numbers.
In order to understand what can positively contribute to the sustainability of your projected numbers, it’s easiest to first look at what things can mess up your numbers. Some of these things may include:
- Tenants not paying rent (decreases income)
- Tenants destroying the property (increases expenses)
- Tenants moving in and out a lot (decreases income and increases expenses)
- The property needing excessive repairs (increases expenses)
- Market rents decreasing (decreases income)
- Property value decreasing (decreases income)
See any trends there? How about tenants, property quality, and market? Those three things will be the biggest determiners of whether you ever see the projected cash flow or not. So then what things matter when it comes to sustaining the numbers you’re planning to achieve?
- Tenant quality. If tenants don’t pay rent, or they cause excessive damage to your property, or you consistently get transient tenants, your numbers will be severely impacted—impacted by repair costs, vacancy costs, turnover costs, eviction costs, and a loss of whatever value you want to assign to your sanity (cost of therapy, maybe?).
- Property quality. If you buy an old dumper that is half-falling apart, you can plan on constant repair expenses. If you budget excessive repair expenses into your numbers and the numbers still work out, cool. But if you buy a dumper and pretend you won’t be constantly paying out to fix it, you’re deluding yourself and your bottom line.
- Location. The location of your rental property will strongly impact its fate. If a market declines, so will the value of your property and possibly the rents. If a market declines, the quality of the tenant pool is likely to decline. If a market continues to grow, on the other hand, so will demand. Demand increases property values, rents, and tenant quality and location is one of the biggest determiners of demand. Location includes both the larger market that you invest in, like the bigger city the property is most local to, and the neighborhood in which the property is located.
The things that contribute to the likelihood of the numbers being positively sustained are also the things that should be considered when thinking of risk mitigation. So risk mitigation strategies for rental properties would include things like buying in less-risky areas, buying properties that don’t pose excessive repair risks, and buying in solid locations.
- Condition of the property
You’re either going to be fixing things constantly, or you’re not. It’s okay if you are but you want to be aware of what that requirement will realistically be before you buy a property. If you don’t budget for repairs appropriately, your profits may quickly start getting eaten up.
Logistics of repair costs and efforts aside, the condition of the property also ties into your goals. If your goal is not to take on a second job as an investor and you’d rather be hanging out at the beach than constantly working on your investment property, then you may not want to buy a fixer-upper that’s going to require a significant amount of your attention.
There’s a big difference, financially and sanity-wise, in a fixer-upper property and a rent-ready property. A rent-ready property means minimal to no work is required on it in order to rent it.
Then regardless of whether you buy a dumper or a rent-ready property, the other question is the overall condition of the property and how easy or difficult maintaining it will be. A newer nicer home in great condition will likely require a lot less maintenance over the course of time as compared to an older cheaper property.
There is no wrong condition of property, except for wrong in comparison to what you are wanting, able to handle, or are budgeted for. Whatever those factors are—what you’re wanting, able to handle, or are budgeted for—should be a forethought as you shop through rental properties.
- Source of the property
Ultimately the source of the property doesn’t matter as long as the property itself checks out. But especially for a newer investor, you may not always know exactly what to look for in order to know whether a rental property checks out and it would be easy for a shady deal to end up on your plate without you even knowing it.
Who is selling you this property? Why are they selling it?
If you buy an investment property from a wholesaler, how credible is the wholesaler? Do they know what actually makes a good deal? If they are an amateur wholesaler with minimal experience, they could pretty easily be connecting you with a trash deal. If they know what they are doing and they have a keen eye for killer investment properties, you might be in good hands.
Did you find the property on the MLS? In an investor’s market, meaning properties are flying off the shelves like hot cakes, a property from the MLS might be automatically deemed a bad deal because in those types of markets properties often don’t even make it to the MLS. If it is on the MLS and it’s a normal market, how long has it been listed? If it’s been listed very long, you can probably assume there are some red flags about it.
Where is the property coming from and why is it being sold? Answers to those two questions can eliminate a lot of the red flags or risk factors that may come with a rental property; even the subtle ones. Again, the source doesn’t matter ultimately, but having some knowledge about these questions can give you a lot more information than you realize.
This one is one that few think about or even realize is a thing. Here’s an example to demonstrate what this means:
You buy the nicest property on the block in one of the nicest neighborhoods in town. It’s scheduled to cash flow and you’re pumped. You think you’ve just found the most rockin’ rental property investment out there. The property inspection comes back clean, the house is great, and you feel like you’re getting a great deal on it.
What could go wrong?
You buy the house and you immediately list it for rent. No responses. Then maybe a response or two, but nothing serious. No prospects. What’s happening? You try to lower the rent some—maybe you overpriced it. Still minimal response. But you got the best property in the neighborhood—what gives?
It turns out you bought too nice of a rental property. In the nicest neighborhood in town, most people buy properties rather than rent. There’s just really not a rental pool in that area.
Rentability. How rentable is your property?
There are a million odd little factors that could make a property less rentable than expected. Rentability should be a question in your head anytime you are shopping for rental properties.
Unfortunately this factor isn’t something you can look up online. The best way to find out how good of a prospective rental property any property might be would be to ask either a real estate agent or a property manager local to the property how the rental market is for that neighborhood. How likely is it to find a good tenant? Is there a solid tenant pool? How are the vacancy rates in that area—is it fairly easy to fill properties?
The numbers, the ability to sustain the numbers, the condition of the property, the source of the property, and the rentability of the property are all key things to have in your head while you rental property shop. All of those things matter. The only potential exception to that list is the source of the property, assuming you are well-versed enough in what to look for so that the source of the property doesn’t matter.
In addition to the things to look for while shopping for rental properties, there are two key things that you should not consider while you shop:
- Estimated numbers. It’s so common to see people analyze prospective rental properties using only estimated numbers. There is absolutely no reason to only use estimates in your calculations, and there is an absurd level of risk in doing so. Only repairs and vacancy expenses should be estimated, and the estimated repairs should only be on-going maintenance rather than anything related to a rehab right off the bat. Property taxes can be found on the tax assessor website for the county in which the property is located. You can get an actual insurance quote. Property management fees, condo or homeowner fees, and any miscellaneous fees like those can be determined ahead of time. If there are no tenants in the property currently, you can offer a real estate agent or property manager some money to run a Comparative Market Analysis (CMA) to come up with a realistic rent for that property. You really want the rent as un-estimated as possible because the rental income is a key factor in your overall investment.
- % rules. If you’ve heard of these, they include the “50% rule”, the “2% rule”, and the “1% rule”. If you’ve looked into rental properties or general real estate investing, you’ve probably heard of these. The 50% rule means that you can assume 50% of the rental income will go to all of your expenses. That would mean that 50% of the income is left over to be placed in your pocket. This has to be the most dangerous rule of them all. Maybe the 50% rule pans out in some cases, but certainly not all and there are plenty of locations where property prices are so expensive that not only will it not fit the 50% rule, but it will require a lot of money out of your pocket each month. That would be quite a nasty finding once you already own what you thought would be a cash-flowing rental property. The 2% and 1% rules say that if the rental income is equivalent or higher than 2% or 1% of the purchase price of the property, it will be a good deal. Sometimes this is true, and the 2% rule is often suggestive of great cash flow, but nowhere in either of those rules does it hit the part about numbers sustainability, as talked about earlier. In a buyer’s market, the 2% may be fitting. But for example, in a seller’s market, any property that meets the 2% rule is likely ridden with risks. Maybe it’s in a dangerous area, or the property is falling apart, or it’s in a trashed city… who knows. So in those markets, agreeing on a 2% property could be highly disadvantageous.
All of the % rules can be used for very surface-level shopping, just to quickly analyze which properties you’d like to pursue further, but once those are determined the % rules should be thrown out the window and only the actual numbers should be analyzed to the best of your ability.
There you have it: your first guide to rental property shopping. By no means will the right answers to each of these checklist items guarantee success, but you’ll be a lot further along in the potential of success if you take the time to look at each of these things. At the end of the day, there’s no better teacher than experience. But hopefully these checklist items allow your “experience” learnings to be less treacherous and more supportive of you reaching your rental property goals.