How to evaluate buying a rental property

Buying a rental property can be very lucrative and sound financial vestment. Here’s how to determine whether not buying a rental property with financing makes sense.

Location, location, location

Location for the property is critical. It is often thought a rental property is more dollars and cents transaction with less focus on location. While this is generally true, a rental property in a fantastic location will always have strong rents, less vacancy, and much better appreciation over time compared with a property that has better cash flow in a less desirable location.

Get real about repairs

Generally, it is a good bet when you can buy a rental property where the rent is greater than the mortgage payment turning your cash flow positive. It is a good idea to allocate at least 5% of the gross rents for the inevitable repairs that you’re going to incur as a landlord. This includes, but it not limited to:

  • new roof
  • new gutter and or repair
  • new paint
  • new kitchen
  • various repairs

Return on investment

How much cash will it take to earn x return is critical. Rate of return (ROI) is your net (after expenses) annual income divided by the capital investment. For example if your net income is 1k per month and your cash to buy a rental is $100k (down payment + closing costs). $12k ÷ $100k = 12% return. Each property will have a different rate of return. What’s the best return to aim for? That depends on your appetite for risk, cash on hand and revenue potential the property the property has.

Property type

This one is big and is by far the most important decision you need to make. For our purposes we are looking at a single-family homes, condominiums and multi-family properties. Here is the list from best to worst-multi-family properties almost always pencil better than a single-family homes. A multi-family home is essentially getting several single-family homes for one.

Here’s the eye popping part for landlords to hone in on, buying a rental such as a duplex allows the landlord to have flexibility when there’s a vacancy. If one unit is vacant the other unit makes up for the loss and vice versa. The combination of more units means more revenue driving potential returns higher.

A single-family homes in a great location can be a sound financial investment. However, if you have a vacancy, you don’t have another unit to offset loss of rent unless you have a single-family home with a granny unit. The granny unit can help offset that negative rental impact on the vacancy. Single-family homes can be solid financial investments as long as you do your due homework.

Condominiums are last on the list as they are the last to appreciate and the first to depreciate in economic cycles. Additionally, you’re sharing units with other owners which makes the income potential is very limited compared to a single-family home or a multi-family property. Taking it a step further, the homeowners association payment can be anywhere between two hundred and four hundred per month. This is a big chunk of your cash flow that otherwise could be used to plan for upkeep or pay a property manager.

Consider the following when evaluating whether a rental makes sense for you:

  • Is the property in a good location that would generate solid revenue and always be desirable?
  • If it’s not in a good location, how much better is my ROI?
  • Is this a property that will need minimal or manageable upkeep over the bigger picture?
  • Remember older properties need more upkeep.
  • How is this benefiting me financially?

As a good rule of thumb make sure you understand all the figures associated with this high ticket investment. The better handle you have on the numbers, the better success you will have purchasing a solid rental property.

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