Updated July 12, 2021
Real estate lures prospective investors on three fronts:
- The holy grail of passive income.
- The opportunity to build long-term wealth.
- A vision of personal independence from the work-a-day grind.
Rental properties can provide a passive income source, although the “passive” aspect is something of a misnomer, especially during the early stages of your journey as a real estate investor.
You stand an excellent chance of building long-term wealth as an owner of rental property—a property you can sell at a profit down the line.
As a real estate investor, you can build a portfolio over time and eventually become self-employed. No need to punch a clock or suppress the urge to punch your boss!
These three factors provide excellent reasons to learn the ins and outs of successful real estate investment. The biggest stumbling block for new investors is the lack of knowledge about analyzing properties for cash flow and profit.
When you do your research on rental markets and can pin-point how the property you have on your radar compares to others nearby in terms of amenities and location, you’ll know if you are looking at a good deal or a dud.
Analyze properties like a pro
Let’s assume you’ve found a rental property you’re considering purchasing. Before you write up that offer, here’s what you need to know about the property.
Any rental property will incur ongoing operating costs and holding costs (assuming you will take out a mortgage to purchase the property.) As a rental property owner, you also need to fund reserves for future repairs and vacancies. Depending on your specific investment goals, you’ll soon learn your base numbers like income and average costs and analyze properties on the fly.
For real due diligence, you need real numbers. Expenses that you will have to take into consideration are:
- Property management fees
- Vacancy rate
- Reserve for capital expenses
- Property taxes
Many seasoned real estate investors use this rule of thumb: If you know the property’s gross rent is $1,200 per month, you should plan on no more than 50% ($600) of that amount to cover operating costs and to fund your reserve. On top of that, you will then have your mortgage payment or other debt service obligation. The remaining amount represents your cash flow each month.
Your mortgage or other debt services will vary depending on how much you plan for downpayment and current interest rates.
Any experienced investor will encourage you to be conservative with your numbers. Ask a lender about current mortgage rates for rental property and requirements for a down payment. You may have access to other financing options, but this exercise will give you a decent estimate.
Consider this actual investor example from a Rentometer Pro User.
Here’s a breakdown of estimated monthly expenses, including debt service and funding the reserve.
Looking speculatively at this property, if you rented it at the area’s average rent rate, your margins would be razor-thin, and you could even lose money.
Your capital and maintenance expenses might be lower, and you may not have a vacancy – but if you cut corners and don’t budget for these potential expenses, those costs will have to come out of your pocket.
How to estimate rents
As you analyze different properties, you’ll also start to learn about neighborhoods where you can charge higher rent if you have the right amenities. Online tools like Rentometer can help you quickly determine if that average or 75% rental rate is possible for any property. Enter the address, number of bedrooms, and number of bathrooms into the search engine, and you’ll see the range for rents: 25%, median, average, and 75%. This information will help you decide if upgrades or added amenities are worth the cost. If the neighborhood supports your hard work and additional investment, you can earn a healthy return.
Take advantage of all the tools at your disposal.
Quick and dirty numbers are sufficient for on-the-spot evaluations. If your initial estimates look good, take the additional time to do your due diligence to analyze properties like a pro. Your basic spreadsheet and data from an online rent evaluation tool like Rentometer will save you time and money and improve your performance as a real estate investor. The bottom line? You can always take a risk and offer a lower amount for the purchase price. However, if your conservative numbers barely break even for net cash flow, you may want to look for better numbers from a different property.
This article was written by the Rentometer Content Team. The Rentometer Blog features fresh takes and insights on rental housing topics, services, and technology. If you liked this article, subscribe to Rentometer's email newsletter to stay up-to-date on the latest trends in rental housing.