How to Analyze your First Rental Property
Guest Post - Written by Tyler Weaver
Analyzing a rental property is the process of determining how a real estate investment will fit your financial goals. The most obvious attribute you will be looking for is a property that costs $0 to hold on a month-to-month basis.
Getting Started As A Real Estate Investor
How to Develop Your Screening Criteria
Your screening criteria will take a bit of time to develop. Since real estate is local, the market constantly changes and everyone’s goals are different.
It is a bit of a moving target.
We can get started by looking at a few common screening criteria that people use when evaluating real estate investments.
The 1% Rule
The monthly rental income should be greater than 1% of the property’s value. This is not a hard and fast rule, and successful strategies can be developed with anything from .7% to 2% rent to value ratios.
This will be the first criteria you use to sift through properties to see what is worth exploring.
This is how you filter down from hundreds of opportunities to a handful that you can look at in greater detail.
The 50% Rule
You can typically expect monthly expenses to be 50% of gross revenue on a property that utilizes professional management. This includes reserves for vacancy and capital expenditures.
Using this rule of thumb, you can quickly be able to identify if the remaining 50% would be enough to cover the mortgage.
When Was The Property Built
This will depend on your investing style. Some people have success with buying houses built in the last 15 years because they then don’t have nearly as high maintenance costs over time.
Others have success buying homes that are older, but have had the major renovations recently, making them effectively newer.
A more advanced strategy is to buy older homes that still require mechanicals and capital improvements. This is how the biggest return on investment can be made.
Floorplan
Determine what size house, how many beds, and how many bathrooms you are looking for. This will likely be a range. Find a sweet spot somewhere around 3 bedrooms and 2 baths in your market.
However, if your goal is to rent to young professionals a 2 bedroom 1 or 2 bath would yield better returns.
Here’s a tip - Compact floor plans cost less to maintain and renovate than larger spacious ones.
Due Diligence
Once the house has passed your initial screening criteria, it is time to start researching the specifics.
You will have to gather some data for this. You can use Zillow to help you with a lot of these. For instance, you can look up other rentals in the area to get a feel for market rent. You can look up the taxes on Zillow or public record.
numbers you Need to determine when analyzing a real estate deal:
Market Rent
Mortgage
Property Taxes
Property Management
Vacancy
Property Insurance
Repairs & Maintenance
Capital Expenditures
The property management, vacancy, repairs and maintenance, and capital expenditures will be calculated as a percentage of rent. Usually, these will be the same percentage for all the properties you are looking at. You may have to make modest adjustments to account for the pros and cons of a property.
For instance, a house with a great location may have a lower vacancy. Or, you could budget less for repairs and maintenance on a new build than you would on a house that’s older.
The market rent, mortgage, property taxes, and insurance will be numbers you can get from the members of your team or look up official records. They are also numbers you can get ballpark quotes or find estimates online while you are in the early stages of research.
Example
In a hypothetical, dream 1%-rule house that costs $300,000 and rents for $3,000 a month, it could look like this:
Market Rent: $3000
Mortgage: $1,200
Property Taxes: $125
Property Management: $300 (10%)
Vacancy: $300 (10%)
Property Insurance: $150
Repairs and Maintenance: $300 (10%)
Capital Expenditures: $150 (5%)
Net Income: $475
With $60,000 down as a 20% down payment, that would be a 9.5% Cash on Cash return.
Don’t get seduced by the numbers, they only tell part of the story!
Trying to maximize returns and looking at the property that has the greatest rent to value ratio, or cash on cash return can lead you towards a number of new investor pitfalls.
Common New Investor Pitfalls
Buying in a neighbourhood that is in decline
Buying a house with excessive deferred maintenance
Not properly inspecting the property
Buying a weird property
Underestimating expenses
Buying In Bad Neighbourhoods
If the neighbourhood is in decline, with no signs of recovery or growth, it is often a sign that it will be hard to get a stable tenant. It can also mean that your equity is at a greater risk of declining over time.
On the surface, a neighbourhood in decline and a neighbourhood on a rebound may look the same. One thing to look for is that a neighbourhood in rebound will have investments in new developments, activity from the local government, and/or an influx of new jobs.
Deferred Maintenance & Home Inspections
Your team will help you do the rest of the due diligence. Getting a whole house inspector to go through all the systems in the house to determine what needs repairs, and what is likely to need repairs in the near future is a key step of due diligence.
You could find out the house needs a new roof or HVAC system that will completely change your numbers.
It is better to know these things before you buy the house, so you have the option to renegotiate the sale, walk away from the sale, or buy it anyway (with a plan to deal with what you are getting into).
When It’s Hard To Find Comparable Properties
The pitfall of buying a weird property refers to buying a house that isn’t actually as marketable as the market rents that you determined earlier. For instance, the bedrooms could be small, the kitchen is a weird configuration, it is on a busy street, or the floor plan is awkward.
Be careful that the rental comparables you select are actually similar to the property you are looking at buying.
Beginning with the End in Mind
I recommend you start with where you want to go with real estate investing and work backwards from there.
For instance, if you want to have $5,000 in passive cash flow 10 years from now, or have 5 properties paid off free and clear, then you can start to figure out where you would have to be in 5, 3, and 1 year from now.
It is important to have the big picture in mind, even though at onset it is hard to be clear how every piece builds into it.
Now that you have seen how the calculations play out into an actual cash return, you can start to play with how different scenarios would impact your return.
Setting your screening criteria is a bit of a feedback loop. You will run the numbers, see how everything fits into your bigger picture and then tweak it until you find something that works for you.
If you are strictly cashflow focused, you will want to set your 1% rule screening criteria as high as possible. Then try to buy the best asset in the best area that meets your screening criteria.
If you are looking to mix growth and cash flow, then you will likely keep your 1% rule screening criteria lower, perhaps below 1% and look for properties in areas that have a higher probability of growth.
Value-Add Strategy (Forced Appreciation)
A great benefit of real estate investing over other, more passive investments is that you can directly influence the value of the property through “Forced Appreciation”. That is, the change in the properties value through your own efforts.
Remember - Just because you are improving the property does not mean you have to be the one swinging the hammer. Forced appreciation can occur through things other than sweat equity.
For a first investment, I would not look for anything that requires a deep renovation or major work.
Look for opportunities to upgrade item such as:
Dated Vanities
Old Cabinets
Flooring
Light Fixtures that need to be updated.
These are the type of improvements that can be easily done by most contractors without tearing into walls etc.
The goal of value add is to add more value to the house than you spend on renovations.
Real Estate Should Work For You
When analyzing a rental property, do not get too caught up in the moment and think you have to buy something that doesn’t feel right. This is an asset that will have to be at some level actively managed, even with professional management in place.
The property should be something that you are comfortable with owning for many years.
The investment should generate positive cash flow after accounting for maintenance, vacancy, and capital expenditures.
Keep these suggestions in mind and you’ll improve the odds that your first investment property will work for you rather than against you.
To read more about real estate investing, follow Tyler at Relentless Finances, where he writes on subjects of real estate, Airbnb, and growing a business.