Running an Investment Analysis on a Rental Property
Renters Warehouse Blog
Rental property is, no doubt, one of the most popular investment strategies in real estate. Why? Its value appreciates over time, it can generate a good return on investment (ROI), and it’s easier to manage than other investments, like short-term vacation rentals. However, like any other investment option, you need a thorough analysis to make an informed decision and to find a property that will generate the returns that you’re looking for.
So how do you analyze your potential rental property? What factors do you need to consider before investing in a property? And what should you look out for when making your decision? In this article, we’ll answer all these questions. But before we dive in, let’s explain what property analysis is and the benefits of performing one.
What Is Property Analysis?
Property analysis is the process of studying an investment property to give an accurate projection of the property’s profitability. This analysis helps you to see what investing in an income property will look like in the long run. It also helps you measure the viability of the property and reduce the level of risk that’s involved.
Analyzing a property doesn’t only allow investors to determine whether or not it’s going to generate a profit; it also helps them to determine the approximate property and rental value. This helps investors make reasonable offers to the seller, and charge a reasonable rental fee to maximize ROI. Property analysis also generally helps investors avoid bad investments since it takes into account factors like the health and long-term potential of the local housing market.
Factors to Consider for Rental Property Investment Analysis
Running an investment analysis on a rental property is as important as the property itself. In order to generate decent returns as a rental property investor, you need to know how to go about the analysis stage. In this section, we’ll discuss the factors and metrics you should consider when doing your analysis.
It’s a common saying that the three most important factors to consider when buying a real estate property are location, location, location. It’s true that location is king in real estate. Just as it affects other investment strategies, location is also very important when it comes to rental properties as well. The proximity of the property to amenities, jobs, good schools, green spaces, and more, directly affects the price, ROI, occupancy rate, and the overall performance of the property.
Moreover, location also has a direct impact on your returns. For example, if you’re looking for a rental that’s occupied year-round, you’re going to want to go where the jobs are. If you’re hoping to have a property that appreciates in value, then you’ll want to find a place where housing values have shown a steady increase over the last ten years or so.
So before signing on the dotted lines, ensure you get to know more about the property’s location. Research more about the crime rate in the neighborhood, look at population growth, and economic growth. Being informed will minimize the level of risk that’s involved.
- Rental Strategy
Rental strategy is another factor to consider when analyzing your investment property. This strategy is subdivided into two: long-term and short-term rental.
- The long-term rental strategy, also known as traditional rentals, enables you to lease your investment property to a tenant for a long term, between a minimum of six months to several years. Its advantages include a higher occupancy rate, consistent rental income, tax benefits, and positive cash flow.
- The short-term strategy, such as Airbnb rentals, allows you to rent out your property for a maximum of three to six months. This strategy doesn't require the renter to sign a lease agreement. It generates high rental income; it’s flexible and appreciates in value. However, it requires high maintenance and understanding of local laws.
For a better analysis of your investment property, you have to decide which type of rental strategy you want to focus on, understand the pros and cons of each strategy, and ensure rules and regulations of your community are favorable to your strategy.
Looking for more information on short-term vs. long-term rentals? Check out: Short-Term Vs. Long-Term Rentals.
- Property Type
There are different types of properties you can invest in: apartment buildings, single-family properties, multi-family homes, townhouses, condos, luxury homes, vacation homes, and so on. These properties all have their own set of rules, risks, and potential returns. Knowing what type of property you’re going to be investing in can help to guide your search and enable you to run an accurate investment analysis.
- Valuation and Metrics
Real estate valuation is the measure of the estimated value of a property to help make a reasonable offer on the property. Valuation also helps you calculate the property’s profitability.
Once you’ve determined the type of property you want to invest in, your rental investment strategy, and the perfect location for the property, valuation should be the next step. Here, you determine the cash flow, ROI, annual income, and more. Below are some of the important metrics to determine profitability.
- Cash-on-Cash Return Metric
Cash-on-cash return (COC), also known as cash yield, is a simple metric that helps rental property investors measure the current and future profitability of their rental property. It’s usually used to calculate the ROI of properties involving long-term loans. This metric provides real estate investors with an analysis of the potential cash distribution over the lifetime of the property.
The formula for calculating cash-on-cash returns is as follows:
Cash-on-Cash Returns = Annual Net Cash Flow / Equity Invested
Learn more about calculating cash-on-cash returns.
- Capitalization Rate
The capitalization rate, also known as the cap rate, is the ratio of the net operating income (NOI) to the current value of the property. It helps calculate the rate of return expected to be generated on the investment property. The ratio helps determine both the investor’s potential return on investment and compares the property’s value to other similar properties.
Cap rate is a return metric used to calculate the risk and quality of investing in the property and to determine the potential payback of capital. It can also be used to calculate the rough estimate of the profitability of the investment property.
The formula for calculating the cap rate is as follows:
Cap rate = Annual NOI/Current property value
The NOI is the expected annual income generated by the property
Property value is the current market value of the property
If the current market value of a single-family property you wish to buy is $304,000, and the expected NOI (after expenses) is $20,000; assuming the price of the property remains the same after the first year, the property’s cap rate would be:
Cap rate = ($20,000/$304,000) x 100 = 6.6%
So after a year, you’re expected to see an ROI of 6.6% on the property.
- Cash Flow
Cash flow is the movement of cash in and out of real estate investments. Simply put, it’s the difference between the money generated by the investment property (gross income) and the total expenses of the property. Cash flow can be positive or negative.
Positive cash flow is when the income generated by the property exceeds the expenses. Negative cash flow is when the expenses exceed the income generated, or, when you’re spending more on the property than you’re making.
Just as any of the other metrics mentioned above (the cap rate and the COC), it’s also very important to calculate the property’s cash flow before investing. Understanding cash flow can help you make better investment decisions and avoid burning your money. It helps you know the potential of the property to be profitable.
So, to calculate the rental property cash flow, you should know:
- The gross income of the property: Revenue generated by the investment property before taxes.
- The expenses for the property: This includes tax, insurance premiums, maintenance costs, and more.
- Comparative Market Analysis (CMA)
Price is another major factor to consider when analyzing a rental property. During your home purchase, figuring out how much a home is worth can be a tedious task. Why? Because it's subjective. Even when you’ve received an offer from the seller, it’s important to be sure you’re not overpaying for the property. And this is why conducting a Comparative Market Analysis (CMA) is important.
A CMA is a comparison tool used by property investors and agents to estimate the value of a property. It compares your property to similar properties sold in the neighborhood. This analytic tool helps generate an estimate (not a definite value) of what you should pay on the property.
Apart from having an understanding of what the property costs on the market, CMA also makes it easier to verify if an investment property is a good deal or not. For example, if your property’s cap rate is 7% and that of similar properties to yours is 4%, you can easily deduce that your prospective property is outperforming the local market.
How Does CMA work?
Simply put, you look for similar properties in the neighborhood (Properties with the same characteristics like room numbers, same bathroom, similar design, and size). And compare the price of both properties.
- Occupancy and Vacancy Rate
Occupancy rate is simply the ratio of rented units to the total units in the rental property. It can help you assess the performance and profitability of the rental property by determining the total number of units that could likely be occupied. For a multifamily building, the occupancy rate can be expressed as:
Occupancy rate = (Total units rented/ total available units in the property) x 100
On the other hand, the vacancy rate is the direct opposite of the occupancy rate. It is the ratio of vacant lots/units to the total units in the apartment building. The vacancy rate can be calculated as follows:
Vacancy rate = (vacant units in the rental property / total number of units in the property) x 100.
These metrics (occupancy and vacancy rates) are important for decision-making. They provide indications of what cash flow would look like in the long run.
In a 30-unit apartment building, 25 units are occupied. The occupancy and the vacancy rate of the apartment building will be:
Occupancy rate = (25/30) x 100 = 83%
Vacancy rate = (5/30) x 100 = 17%
Steps to Perform Rental Property Analysis
Apart from helping eliminate the risk associated with rental property investing, property analysis helps investors think ahead of time and prepare for likely scenarios and contingencies. It’s an important step that can make or break your investment goal.
Below are the steps you will need to follow if you want to perform a rental property analysis:
- Investigate the Rental Market
While it is required for real estate investors to be detail-oriented, they also need to understand the big picture of the local real estate market to accurately analyze a property. Understanding the bigger picture means that you need to make sense of the rental market where your prospective property is located.
As we’ve seen, location is very important to real estate. It’s even more important to rental property investing because it’s going to affect the property’s price, rental costs, expenses, and occupancy/vacancy rate.
So, before you make an offer, understand the real estate market by researching the population growth, economic growth, job market, property tax and insurance and price-to-rent ratio. You should also have a better understanding of the current real estate market situation.
- Evaluate the Neighborhood
Once you’ve analyzed the real estate market, the next step is to evaluate the neighborhood where the property is located.
Since there are often many different neighborhoods and districts in a region, it’s important to conduct a localized neighborhood analysis. You should know that a booming rental market doesn’t mean that all neighborhoods will be worth investing in. Check for the neighborhood occupancy rate and overall neighborhood vibe.
Know that no matter the level of neatness of your property, the location of the property will impact your ROI. Having a luxury property, for example, in an unkempt neighborhood with a high vacancy rate will impact your property.
Reducing your hunt to a micro-level analysis will reveal more detail about the rental market. From here you’d know more about different districts and communities, and you’d certainly know more about the city’s best and worst performing communities.
Some of the factors to consider in your neighborhood analysis are:
- Crime rate
- Employment rates
- Local laws
- Accessibility to public amenities, and public transportation
- Proximity to local schools
- Research the Property
After investigating the rental market and evaluating the neighborhood, your next line of action is to intensively evaluate the property you intend to buy. The purpose of this stage is to know more about the property.
Perform a property valuation using all the metrics we discussed above (COC, cashflow, cap rate). Check out for the property history, occupancy rate, repairs required, and so on. Do not forget to crunch some numbers to confirm the value of the property. Ask questions and clarify everything with your real estate agent first.
- Perform Comparative Market Analysis (CMA)
Finally, here is where you determine the fair market and rental value of the property using a comparative market analysis (CMA) tool. This is a comparison tool for contrasting your property to other similar properties in the neighborhood.
Apart from helping you determine the fair market and rental value, CMA is also used to determine the average occupancy rate and cash flow you should expect from your investment.
To make a perfect analysis using CMA, look out for properties of the same size in square feet, the number of bedrooms and bathrooms, amenities, etc.
Looking for more information on finding a good investment? Spotting a Good Investment Property can help give you some more tips.
The Bottom Line
Property analysis is an important step in making informed decisions on your investment. It helps you to make an accurate projection of the property’s profitability. Although it’s not the only thing to consider when investing in rental properties, it’s tremendously important nonetheless. In fact, running an investment analysis should be one of the first steps when considering whether a property is a viable investment.
Want to start your search for rental property? Search our inventory of available properties for sale. And be sure to check out our Market Research Center where you can see up-to-date property data on housing markets across the country. Find information like population growth, employment rates, housing appreciation, and more so that you can make informed decisions on potential properties.
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