Rental properties represent the pinnacle of most real estate investing strategies, and for good reason: few investment vehicles award entrepreneurs the opportunity to build long-term wealth passively. It is entirely possible for a great rental property to generate profits for generations. That said, not all rental properties are created equal. While some are overflowing with potential, others are best left alone. Those who know how to differentiate between the two will find the odds stacked in their favor. Meanwhile, the ability to determine a good rental property is a skill every passive income investor needs to learn sooner rather than later.
The concept of a “good” investment property is entirely subjective. There are simply too many variables for a single, universal qualifier to apply to every property. That said, there are some important things to look for when determining a rental property’s viability; namely, the one percent rule. Many investors abide by the one percent rule that roughly suggests what an asset’s net operating income (NOI) should be for investors to consider buying in. More specifically, however, the asset’s monthly income should be at or around one percent of its value. Subsequently, that one percent should be enough to offset each and every expense incurred.
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When looking for a good rental property, there are a number of indicators to take into consideration. Below you’ll find some of the most important factors to consider when buying a rental property:
There is a single rule all real estate investors must abide by, regardless of their exit strategy: location, location, location. The location in which investors choose to invest will undoubtedly play an integral role in how well their assets perform. You could argue, however, that nowhere is the location of a real estate asset more important than in the rental community. Where a rental property is located will not only determine the physical property’s potential, but also the quality of renters that are to live in it. Remember, you can always change the features of a home, but you can’t change its physical location. Therefore, the first step in learning how to determine a good rental property is to vet the area where the home is located.
Mind due diligence and research the surrounding area you intend to invest in, as the performance of rental properties are intrinsically tied to a respective neighborhood’s status. A good neighborhood, for example, will boast several healthy socioeconomic indicators, not the least of which include:
While not the only indicators to look for in a rental property and its surrounding area, all of these factors need to be taken into consideration. When these things skew positively, rental properties are much more likely to realize attractive profit margins.
The next thing investors should do in order to determine a good rental property is to gain a better understanding of the area’s property taxes. If for nothing else, property taxes are not uniform across all neighborhoods in a given city; they may not even be uniform in a respective neighborhood. It is entirely possible for homes no more than a few hundred yards apart to brandish significantly different property taxes. As a result, it is in the best interest of investors to be aware of what they can expect to pay in taxes on a given property.
Investors who know how much money they’ll be losing to taxes will be able to calculate their projected cash flow more accurately, making their exit strategy that much more sound. At the very least, it’s impossible to know how much cash flow a rental property may net its owner without calculating each and every expense. It is worth noting, however, that high property taxes aren’t necessarily a bad thing. In the event the neighborhood is in excellent condition and demand remains intact, the long-term tenants it attracts maybe worth the higher property taxes. To find out the property tax rates you can expect in a given community, check with the local municipality’s assessment office.
As with just about every real estate investment, profit margins are paramount—the asset must be worth the initial investment. In addition to property taxes ( and other expenses), rental property investors trying to determine the viability of a subject property need to account for maintenance and repairs. The amount of money one can expect to spend on rehabbing the property (in order to bring it up to acceptable renting condition) needs to be taken into consideration when determining whether or not a home is worth buying. Prospective rental property investors can’t simply look at the asset’s asking price; they must factor in maintenance and repairs to their budget. Not only that, but the expected cash flow needs to be enough to offset the expected costs. If, for example, the home will cost too much to fix to warrant its purchase, there’s no reason to buy the property. On the other hand, a great property in a great location could easily warrant making a few repairs. Quite simply, investors just need to make sure the expected return on investment is worth the upfront costs.
Costs play an integral role in building a rental property portfolio. After all, it’s true what they say: you need to spend money to make money. The secret, however, is to spend much less than you are making in profits—a simple concept, but nonetheless an important lesson to heed.
In learning how to determine a good rental property, prospective investors need to identify each expense—including those that recur each and every month. Take note of all of the holding costs associated with a property, including (but not limited to): mortgage payments, property taxes, utility bills, insurance, homeowners association (HOA) fees, property manager fees, and anything else you would expect to pay on a regular, monthly basis. The idea, of course, is to determine how much the property will cost to hold onto each month, and to then compare its costs to the expected cash flow (which we will get into later).
While the amount landlords can charge in rent will vary dramatically from neighborhood to neighborhood, a general rule of thumb suggests a fair asking price is somewhere around 0.8% and 1.1% of the home’s value. Monthly expenses can’t exceed 0.8% to 1.1% of your home’s value (or whatever you intend to charge).
Cap rates are an easy and dependable strategy to implement when quantifying whether or not an investment deal is worth pursuing. In its simplest form, a cap rate is an equation; one that’ll identify how much an investor stands to make (or lose) if they purchase the property in question. It is worth noting however, that a cap rate won’t provide investors with an exact amount, but rather an estimate. In order to calculate the cap rate of a property, you’ll need two things: the asset’s net operating income (NOI) and its acquisition cost. Then, divide the property’s NOI by the current market value or acquisition cost of the home.
Cash flow, as its name suggests, is a simple value that accounts for the amount of cash left over once an investor has accounted for all of their capital expenditures. As a result, cash flow is one of the single most coveted indicators in a rental property; it’s the money you’ll be able to “take home” at the end of the day. Cash flow isn’t guaranteed to be positive. It is entirely possible for an asset’s cash flow to be negative. Therefore, investors need to make careful cash flow calculations before they commit to an asset. Those able to accurately calculate rental property cash flow are given insight into the potential of their property.
Investors who know what to look for in a rental property will increase their chance of realizing success. Fortune, after all, tends to favor the prepared. Meanwhile, knowing how to determine a good rental property is essentially the first step towards preparing a lucrative rental portfolio. If you want to tip the scales in your favor, be sure you know what to look for when buying an investment property.