Building a portfolio of rental properties is an excellent way to increase wealth over time. However, there are a ton of things to think about before jumping into a deal.
How do you know if it’s a good investment? What things should you be looking at in order to make your decision?
This article will outline a variety of simple steps to take when analyzing a potential investment property. It includes a series of formulas, calculations and things to consider so you know whether or not it’s a good deal for you. No two deals are the same and no two investors are the same, so it will vary depending on your specific situation.
How to Analyze Potential Income
The potential income you can earn on a property is the first step in your analysis and there are several ways to do this. For this discussion, we will assume that the only income for the property will be monthly rent. Some properties also have storage, parking, laundry machines and other income, but we will assume only rent for now.
Gross Rent Multiplier (GRM)
The Gross Rent Multiplier is the sales price for that property divided by the total annual rent that you anticipate being able to collect. In this scenario, use the asking price on the property as your sales price. You might be able to get a better deal by negotiating well, but using the asking price will keep you on the conservative side as you do your calculations.
To determine how much you can charge for rent, take a look at other properties in the same neighborhood or similar neighborhoods. Do some comparative analyses of what other renters are paying for similar homes in similar neighborhoods. This will help you determine what you can charge for the property.
Now, you can simply do the math: sales price divided by total annual rent. This will give you a single number. It’s not a percentage or a number on a scale, but when you do the same analysis on multiple properties, you can compare them all to see how the GRM differs. The lower the GRM, the better.
The 1 Percent Rule
In a nutshell, this rule says the monthly gross income should be equal to or greater than one percent of the purchase price. Your monthly gross income is the total amount of income you are collecting on the property. Since we’re only talking about rental income in this discussion, this number is simply the amount you intend to charge for rent.
This is another great way to compare properties. Some will be within the one percent rule and others will not. It doesn’t mean you should walk away if they aren’t, because there are tons of other factors that affect the value of a deal, but it’s a great thing to look at while you’re doing your analysis.
This calculation is the gross income minus the expenses. You can calculate this on a monthly or annual basis, depending on which specific number you’re interested in. If you want to know your cash flow, or how much you’ll be putting in the bank each month, calculate the monthly net income.
Your total income is the amount you will charge for rent and your total expenses will include your; taxes, insurance, HOA fees, utilities, and more. It is anything that you plan on paying for. Some landlords will wrap the cost of utilities, lawn care and other services into the rent payment and others will leave that to the tenant to pay. There’s no right answer, but be sure that you identify what you’ll be paying vs what the tenant will be responsible for.
To do the calculation, simply subtract your total expenses from your total income. This will give you an approximation of how much income you can plan to receive from this property on a monthly basis. If you want the annual figure, multiply the monthly rent by 12 and the total expenses by 12, then re-do the calculation.
*Pro Tip: Smart investors set aside a little bit of money each month for repairs, capital expenditures and vacancy. Be sure to include these items in your list of monthly expenses on the property to get a clear picture of net income.
Cash on Cash Return
This is a measure of the percent return that you can expect to have on your investment. It is the net income divided by the total investment. For this calculation, you need to consider the annual net income, rather than monthly as we calculated in the previous section.
To determine your total investment on the property, you will add the down payment, closing costs and the amount of any repairs you plan to do prior to allowing tenants to move in. It is basically all the cash that you have to invest while purchasing and upgrading the property versus the amount of money you are putting in your pocket every month.
Once you have all of the income and investment costs calculated, simply divide the income by the investment amount. This will give you a number with several decimal points. Multiply that number by 100 to find your return percentage. In this calculation, the higher the percentage, the better.
What Other Factors Are Important Besides Income?
Obviously, the numbers are the biggest indicator of whether or not a deal is actually a good deal. However, there are other factors to consider after determining that the numbers are working in your favor.
Housing Market Trends
One of the most important factors to consider after crunching all the numbers is the future of the property. You want to do some research on the current market value as well as what you think the house will do in the future.
The trends of a particular neighborhood or area of town will help you to better understand what this property is likely to do. If you look at some comps and they all seem to be losing value, you may want to reconsider the purchase.
If you’re planning on keeping the property for 10 or more years, it might be okay to purchase it even if the trends for that area aren’t going up right now. Regardless of trends, if you keep it for that long, you are likely to build a lot of equity in the home.
But if you’re planning on renting it out for a few years and then selling, you may want to look elsewhere. If the property values in that area come crashing down, you may find yourself upside down with the mortgage payments.
Commercial development projects can have a huge impact on residential neighborhoods. Sometimes they can increase home values and sometimes they can negatively impact them. You should do some research on this, as well.
For example, a historically low value neighborhood that is undergoing some major commercial development is a really great opportunity for investors. If you get into the space at the right time, you can find some fantastic deals. “Buy low and sell high” as they say…
Purchase a home as low as you possibly can, keep it until the market recovers and grows, and then sell it for a much higher price. In the meantime, you can do a few upgrades and rent it out to pay for the mortgage. If the commercial development around the neighborhood is adding restaurants, retail locations and other amenities, chances are that the home’s value will increase as those projects are completed.
Equity is a huge piece of the puzzle that many investors forget to consider in their calculations. It is absolutely possible for several of the formulas above to give you less-than-desirable results and the deal is still a good one.
Why? Because at the end of the day, equity is king. (Well, cash is king, but maybe equity is the prince).
Simply stated, equity is the difference between the home’s market value and the amount you owe on the mortgage. If you have $50,000 in equity, that’s how much you should walk away with if you sold the house right now at market value, assuming all closing costs and other fees were covered by the buyer.
How Do I Increase Equity?
There are a variety of ways to ensure that you have plenty of equity in your rental property when it comes time to sell it.
The Down Payment: The minute you put a down payment on the property, assuming it’s a fair purchase price, you have at least that amount of equity in the home. If you have the cash to use, it can be a really good idea to put more down so you get better interest rates and lower mortgage payments.
Buy at a Discount: If you buy the home for a discounted price, or less than market value, you automatically have even more equity. Try to find a short sale, foreclosure, estate sale, divorce or someone who needs to get out quickly. People in these situations are generally highly motivated sellers and you can find a reasonable deal that is good for both parties.
Add Value: If you add value by doing various upgrades and renovations, you can almost force the property to appreciate in value. This can be a hit-or-miss strategy, so be sure to do your comp analysis to see what other properties in the area have and what they’re selling for before you spend a ton of money.
Buy and Hold: This is the most basic of all equity growth strategies. You basically buy the property and hold on to it for a long time. Pay the mortgage down over that time and you will naturally build equity.
Passive Price Appreciation: This strategy is very similar to the scenario we discussed regarding commercial development. If you choose properties in the right locations, it can be a great strategy for long-term ownership. If the neighborhood is up-and-coming, it can appreciate quickly.
How Much Work Does It Need?
Although you calculated these costs into many of the calculations earlier, it is still necessary to do a deeper dive. If you’re buying a house that needs to be renovated, you need to be strategic in doing so. Here are a few tips and tricks regarding renovations and upgrades.
Don’t go custom. You might love bright colors, funky patterns and custom designs, but this is an investment property – not your forever home. Resist the temptation to put in a bunch of custom fixtures and high-end features. The goal is to make the place safe, livable and appealing to the majority of people who will see it. Stick to the basics and save money in the process.
Use individual businesses for repairs. If you’re not able or willing to do the necessary repairs yourself, you should use individual service providers for the different items that need to be fixed. For example, if you need some plumbing and electrical upgrades, along with new carpet, it is tempting to get one general contractor to bid the whole job for you.
This is a BIG mistake. That general contractor will likely cost hundreds or thousands more than if you reached out to a plumber, an electrician and a flooring company. Your goal is to spend the least amount of money possible while making the property safe and livable. It doesn’t have to be perfect.
Only complete the necessary repairs. If you’re not planning to flip the house, there is no reason to go in and immediately rip everything out and replace it. As previously stated, you’re just trying to make it safe and livable. Do a full assessment of the home, or use the home inspection document from the purchase process. Choose the items that are the highest priority and complete those first. Then rent it out and start making that money back.
Over time, you can make other repairs and upgrades. But remember, your goal is to make money, not spend it, so only do what is necessary.
Buying a rental property is a huge investment. It is well worth your time to do the research and calculations on the front end to avoid painful consequences of a bad deal on the back end. Take your time to evaluate each property and find the deal that is best for you.