“I bought a duplex once and lost money.”
We all have an uncle who told us his investment story when we mention we want to buy an investment property.
The difference between you and them is after this article you’ll know how to evaluate a rental property with ease and clarity. Your uncle probably didn’t do the proper due diligence, no offense.
To properly evaluate a rental property you’ll need to understand a few key principles you can use in any analysis. Let’s take a look!
How to evaluate a rental property
The cash on cash return metric is the most important financial factor when evaluating a rental property. This metric along with other key factors are crucial in your analysis when adding real estate to your portfolio.
What are the types of rental properties to buy?
The first thing you need to know is what type of property you want to purchase and rent out. For beginner investors, the simplest starting place is 0-4 units or 5+ unit properties.
The reason is because properties with 5 or more units require a commercial loan as opposed to a residential loan. For the sake of simplicity, we’ll focus on 0-4 units. These properties are also easier to acquire since the larger investors typically focus on 50+ unit properties.
Within the 0-4 unit range, we can break it down into single family, duplexes, triplexes and fourplexes.
What is a good cash on cash return for a rental property?
If a passive investment like the stock market can produce a 50-year historical return of 8-10%, a rental property that requires a higher initial investment and an active approach ideally would need to yield more than the stock market to make sense.
When I’m analyzing a deal, I shoot for a 20-25% cash on cash return. This means I will get all my invested money back in 4-5 years.
The cash on cash return measures how quickly you’ll be able to recoup the cash you initially invested. A 10% return means it will take 10 years to recoup your funds.
What adds the most value to a rental property?
There are a few areas to focus your rehab budget when forcing equity in a property:
- Adding a bathroom or bedroom
- Kitchen updates
- Bathroom updates
- Adding laundry
By ‘value’ I’m referring to what will have an immediate impact on demanding a higher rent. Although a new roof, furnace or water heater is important, these are more baseline requirements if you plan to sell or rent out a property.
How much does it cost to buy a rental property?
Out of pocket, it will cost anywhere from a 3-20% down payment plus closing costs. The lower down payment percentages are allowed when you choose to ‘owner-occupy’ or live in the property (2-4 unit properties).
My first deal was a triplex that I house hacked. The purchase price was $126,000 and I put down 3% so all in it cost me approximately $8,000 to purchase the property. Only one of the units was renovated so I ended up completely gutting 2 of the 3 units.
A general rule when buying properties is if you are NOT planning to occupy the home or claim it as your principal residence, plan on paying 20% down plus closing costs.
How to evaluate a rental property (Step-by-Step)
1. Analyze the property location
You may have heard the phrase, ‘location, location, location,’ in the real estate world. The property location is one of the most important factors in your purchase decision.
For beginners, buying real estate ‘in your backyard’ is recommended. You have a better understanding of your local market in terms of population, job outlook, schools, and rent demand.
2. Analyze the 1% rule
Performing a quick analysis of a property will help determine if you need to move on or go further down your due diligence checklist. The 1% rule will help with this.
If the gross rent is 1% of the purchase price or more, the property may be a contender:
Property Type: Duplex
Purchase Price: $175,000
Current Rent: $925 per unit
$925 x 2 Units = $1,850
$1,850 / $175,000 = 1.06%
So, if you can get the property for $175,000 or less, you have met the 1% rule and move further into your analysis.
Why does the 1% rule work in real estate?
Generally, if the property meets the 1% rule test, you will be profitable each month. I mentioned gross rent in the example. After subtracting out operating expenses you should have a positive net operating income each month.
3. Analyze current lease agreements
In any offer I’ve written on an investment property, the offer is always contingent on reviewing the current lease agreements. Here are a few things to look at in the lease:
- If the owner and tenant have a written agreement
- If the rent amount equals what is stated in the listing
- Security deposit amounts
- Process for late rent
- Who pays utilities – This can have a major impact on your profit and loss
- The lease term – 6 months, 12 months, month-to-month
- If pets are allowed and at what extra fee
You need to be guided by the lease in place, not taking the word of the prior owner. When in doubt, make sure things are in writing!
4. Analyze anticipated repairs
There’s a wide range of potential repairs that can impact your monthly profit. The property could be anywhere from ‘move-in ready’ to needing thousands in repairs.
Ensure big ticket items like the furnace, water heater, plumbing and electric are functioning properly. The roof is another big ticket item to consider. A standard roof should last 30 years so make sure you find out the installation date.
For your first property ideally you want something that needs fresh paint and some light updates so you can get the property rented. Or, if it is already occupied by a tenant you can wait to do these repairs at a later date.
5. Analyze value-add opportunities
Where can you add value to a property to force equity? Below is a list of items to look for when walking through the property.
- Updates to the kitchen and bathroom
- Curb appeal – Basic landscaping on the exterior
- Can you add laundry?
- Can you add a half bathroom or bedroom?
The key is to invest in updates that will yield a return on your cash. For example, adding laundry will allow you to raise the rent immediately.
6. Analyze the cash on cash return
Cash on cash return is the most important metric when I’m analyzing a property.
Annual Cash Flow / Total Invested Cash
In any investment you need to determine how long it will take to recoup all your funds to achieve profitability. Here’s a back of the napkin example to quickly determine cash on cash return:
Purchase Price: $175,000
Property Type: Duplex
Financing: 20% Down Payment, Conventional 30-year Fixed Loan
Total Closing Costs: $35,000 + $3,000 (Down payment + closing costs) = $38,000
Gross Monthly Rent: $1,800
Net Monthly Cash Flow: $1,800 x 60% = $1,080
Annual Cash Flow: $1,080 x 12 = $12,960
Cash on Cash Return: $12,960 / $38,000 = 34%
I aim for a cash on cash return of 20% or more in my analysis. This is because it needs to produce a higher return than other passive investments like stocks, ETFs or crowdfunding.
Mistakes to avoid when evaluating a rental property
Overlooking red flags in a property due to the excitement of purchasing can end up completely wiping out your profitability. Here are a few mistakes to avoid in your analysis.
- Not reading between the lines – In a way, you are taking over a seller’s problems when you buy a property. Ask questions about the seller’s plans to find the real reason they are selling.
- Not working the numbers in your favor – Ask for concessions or a small price reduction if you find repairs that need to be done. A seller will likely agree in order to get the deal done.
Final Word on how to evaluate a rental property
Adding real estate to your portfolio can help to build generational wealth. Performing a proper analysis can not only give you confidence going into the deal, but also improve your profitability.
There are other metrics and analysis that can be done but at a certain point you’ll have to jump in. The majority of your knowledge will come from handling issues after the purchase.
You do not need to have all the answers up front. As long as you have a base knowledge of analyzing a deal and know WHO to contact when issues arise, you’re ready to start your real estate investing journey.
