How to Analyze Rental Property Investments
While real estate is a relatively stable industry, a lot of thought still has to go into it to maximize returns. You might know one or two investors who seem to have an eye for the business and wonder how you can recreate their magic touch.
In truth, learning to choose a successful rental property lies in your evaluation. Although sometimes, forces out of our control can sway the results. More often than not, thorough market research and preparation will come out on top.
In this article, we'll be highlighting the proper way to analyze rental property investments for better returns.
1. Develop a rental strategy
Before you get into anything, the first thing to do is carefully consider your rental strategy. Having a clear plan in mind acts as a guide for the rest of your analysis and ensures you achieve your business goals. Do you intend to offer short-term leases as a way to pay off your mortgage? Or are you after long-term tenants that will guarantee a steady passive income? If you want a vacation rental that will act as a second home, that will also influence your plan's layout and eventual execution. Once you outline your needs and your most convenient means of financing your new investment, you'll enter the market knowing what you want and don't want.
2. Evaluate the Location
Location is a prime factor in determining the performance of a rental property. It is literally where the foundation of your business is built, and if it is not desirable, you stand to lose a lot of money.
It would help if you toured the area you have in mind for desirable neighborhoods or sought the assistance of an expert real estate agent. It's well known that rental properties tend to appreciate. But this doesn't happen at the same rate, so look out for properties with the potential to substantially increase in value in the following years.
3. Determine the right tenants
Next, building on your rental strategy and location, you need to decide your target market. If you're purchasing a vacation rental, then tourists. But if the area is a known romantic getaway, you can be more specific in setting up your rental to accommodate couples. On the other hand, if you have prime real estate close to universities, you're better off aiming for young adults. Your decision at this stage will further influence what marketing strategies you adopt to draw in the right audience. Tenants are crucial in making your rental property business succeed, so you'll most likely struggle if your strategy and location don't suit your target persona.
4. Perform a comparative market analysis (CMA)
Following your decision on who your target market is, you need to start gathering data to perform a comparative market analysis. As you might guess from the term, a CMA involves looking at the current rental market and comparing it to your own. Identify similar properties in the area in terms of rental type, location and amenities provided. How much does the competition charge? How many vacancies do they have? What's the average tenant turnover rate in the area? These are the sort of questions you should ask during your analysis. If your research is thorough, you should arrive at a fair market value for your units.
5. Get an estimate of the Net operating income (NOI)
No rental property analysis is complete without measuring the Net Operating Income. The NOI represents your expected profit after subtracting your operating costs from your total revenue. In other words, it is:
Total Income - Operating expense = NOI
At the risk of stating the obvious, your NOI should be positive.
In addition to letting you know if your business is profitable or not, the NOI serves another purpose. It provides insight into how much you earn or spend on certain services. If you'd like to increase your net revenue, you might consider some upgrades to justify increasing your rent or installing a laundry room in your building. Alternatively, you could also reduce your expenses by opting for energy-efficient appliances that consume less electricity and subsequently reduce your electric bill.
When it comes to analyzing metrics, your first step should be to find the net operating income for the property. NOI is a measure of the revenue the property will generate after accounting for operating expenses. While NOI is not enough to get a complete picture of the profitability of a property, it does form the basis of many other equations you'll use in your analysis.
Other metrics for your analysis
Other ways you can analyze a rental property investment include:
Cash-on-cash return: Your cash-on-cash return is your NOI divided by the amount you paid for the property, including your closing costs. It tells you the value of your investment relative to how much you've spent on it.
Capitalization rate: Also called cap rate, it is your NOI divided by the property valuation. While a high value indicates a higher chance of reward, the same applies to the risk you have to bear.
Analyzing the likelihood of success of a rental property isn't as easy as punching 2 + 2 in a calculator. What determines the success of a property depends on several factors, and you have to evaluate each one carefully. That's why it's crucial to work with a local professional who understands your market and can help you acquire prime realty.