Summary: In this article, you will learn how to determine a good rental property, what to look for, how to analyze the numbers and what is considered a good return on an investment property.
What should I look for in an investment property? This is a common question for real estate investors. Learning how to determine a good rental property will mean the difference between a profitable investment and a bad investment.
There are a number of factors that go into determining if a rental property is a good investment. This article will explain when to buy based on market cycles, where to buy, what type of investment property to buy, and what is a good return on an investment property.
When to Buy Rental Property
Understanding market cycles will help you decide when to buy. To do this, you need to be able to recognize if the area you’re looking at is a seller’s market or a buyer’s market.
As we are looking to buy a great rental property, we want to buy during a buyer’s market. A buyer’s market is when there are many homes on the market and not a lot of buyer’s – giving buyer’s all the power. Buy during a buyer’s market. Sell during a seller’s market.
Where to Buy Rental Property
Just like the weather, real estate is very location-dependent. The real estate market can be hot in one town and cold in the next. Even within the same city, you can have more than one real estate market. The location of a property is typically considered the single most important factor in determining its value.
You want to look for a property in a good neighborhood, in a good school district, close to jobs and local amenities. All of these factors will likely increase the value of your rental over time – as long as these factors stay the same.
How to Spot Good Locations
There are great markets all over the country. In every state, you can find pockets of markets on the brink of growth. Here is some of the criteria we look for:
- Is it located near a big city? Big cities can offer job diversification, along with culture, nightlife, and convenient amenities.
- How big is the population and is it growing? Look to invest in cities with over 1 million residents. In most areas, around 40% of the population rents, which leaves 400,000 potential tenants for your rental property.
- You don’t have to buy a property in a big city. The key is to look at an entire metro area to determine the best neighborhoods. You may find that there is actually a greater demand to buy in the suburbs of a big city, where the crime rates are lower, schools are better and the amenities are nicer. Don’t buy too far away from the city as people generally don’t want to live more than 30 minutes away.
- Is it in a good market? Investors can determine if the area is experiencing a buyer’s or seller’s market by checking inventory levels and how long it takes for a property to sell (average number of days on market, or DOM).
- Are home prices increasing or decreasing each month? A good rule of thumb is to look at home value trends over a consecutive three month period.
- Is there rental demand? Websites and local property managers can provide information about rental demand in the area.
- Does the area have a low median or average home price? Median home prices are basically the middle of the road properties. In an affordable market, the average home price should be no more than 3 to 4 times the average income.
What Type of Rental Property Should I Buy?
There are a number of ways to make money in real estate. You may choose to invest in a commercial property, industrial property, an entire apartment complex or a single-family home.
Whatever you decide is the best route for you, pick one, learn the ins and outs, stick to it and become an expert. You can’t do everything, if you want to do it well. Choose the strategy that works for you and put your energy into that alone.
The single-family home is the simplest way to get started as a new real estate investor. And many expert investors will tell you it’s the very best investment in real estate. From our experience, the best type of single-family homes have at least 3 bedrooms and 2 baths.
When you think about what you look for in a home for your family, chances are it’s a single-family home and not a duplex, triplex, condo or apartment. Single-family homes are a lot easier to both rent and sell than multi-family homes.
If you are trying to sell a multi-unit property, most likely other investors will be looking to buy it. As we well know, investors are always looking for a deal and don’t want to pay full price. Whereas single-family homes can be sold to the public at retail price. If your property is affordable to the average buyer, you should expect to have plenty of demand when you choose to sell or rent.
This is especially true when you’ve taken the time to buy a good rental property. Where it’s located in a good neighborhood, with good schools, close to jobs and access to local amenities.
More reasons we like to invest in single-family homes:
- Easier to upkeep
- Higher quality tenants
- Faster appreciation
- Easier Financing
- Affordable price points
How to Analyze Investment Properties
When you’re out looking at potential investment properties, it’s important to know how to analyze them. Assuming you’ve followed our tips on where to buy, you then need to run the numbers. This includes the projected rent and appreciation and all the costs or expenses associated. Don’t forget to include, closing costs, escrow fees, taxes, potential vacancy and mortgage fees.
While there may be a lot of expenses, remember to take into account monthly rent, appreciation of the property, yearly increase in rent and tax breaks you qualify for. Every single time you look at a home, make sure to use your cash flow analysis equation and let the numbers speak for themselves.
After you’ve broken down all the numbers, you can then decide if this rental is going to fit your investment strategy and produce positive cash flow. If you’re unsure how to calculate cash flow returns on a property, visit our website to download a free cash flow analysis spreadsheet.
To recap, here’s how to determine a good rental property:
- Located in a desirable area near jobs
- Ideally in a metro area with over 1 million people
- Single-family homes
- Well-maintained and updated
- Priced in the median range for the area
- Priced between $100,000 to $200,000
What is a Good Return on Investment Property?
Depending on who you ask, anything above a 15% ROI could be considered a good return on a real estate investment. However, there are a few ways to accurately calculate your potential return on investment.
The return on investment (ROI) is a measure used to evaluate the efficiency or profitability of an investment. In other words, the amount of return relative to the investment’s cost.
ROI = Annual rental income / Total cash investment
Calculating Capitalization Rate
The capitalization rate or cap rate, is the rate of return on an income property based on the net operating income (NOI). The cap rate shows the rate of return taking into account your method of financing. Investors generally consider a good cap rate above 8%, and especially 10%.
Cap rate = NOI / Price
Calculating Cash on Cash Return
A cash on cash return or CoC return, measures the annual return on your investment based on the NOI and the total cash investment. Your CoC changes depending on different financing methods. Generally, a good CoC return is above 8%, but aim for above 10% or 12%.
CoC return = NOI / Total cash investment
Unlike the stock market, real estate is easier to predict, if you know what to look for. To stay on top of market cycles in the area your rental is located, you need to pay attention to any changes.
Simply go online and look for school ratings, local employers, crime rates, rental rates, home rates and population shifts. If you notice negative things happening in that area, you can always decide to sell your rental property before values begin to decrease and buy in an up-and-coming neighborhood.
According to Founder and Co-CEO of RealWealth, Kathy Fettke, staying ahead of market cycles, is even more important than location. Fettke explains, “If you ignore the markets, you wouldn’t know if employers moved to a different side of town, or whether or not the school district was keeping up with its high ratings. You wouldn’t know if crime had moved into the area or if the local economy had shifted. …market cycles are even more important to notice throughout the life of your asset.”
Fettke, Kathy. Retire Rich with Rentals. 2014.