How to Analyze a Rental Property
- Jun 17, 2019
- 6 min read
Updated: Mar 24
The numbers come out, the charts pile on, and it's a S-L-O-W death by calculator boredom, with the occasional painful flashback to 9th grade algebra. Well, hold on to your socks because I have good news for you... not only is rental property analysis not nearly as complicated as some may think, but it can actually be kind of fun. Yep, I said it—'fun.'
You don't need advanced math skills to analyze a rental property, just a basic understanding of simple math, key investment property metrics, and a calculator. Whether investing in a single-family rental property, an apartment complex, or another type of real estate investment, knowing how to evaluate a rental property is essential.
Essential Steps for a Profitable Rental Property Analysis
When evaluating the financials of an investment property, the analysis should be broken down into three distinct phases, in a straightforward manner.
The figures for the sales comparisons or regional cap rate
The figures for the rental comparisons
The figures for the property's income and expenses.
Aside from the numbers, you should also look at, the neighborhood, determine the area's unemployment rate and whethrentaler the median local income can support at least 2 to 3 times the average rent amount of the rental property you are seeking to purchase.
A strong real estate market analysis is easy using tools like Zillow Rental Market Trends and is crucial for a value-add real estate investment aimed at higher rents; if local income can't support it, upgrades won't help. Also, compare your competition's rental rates, property quality, and amenities.
Water Cooler Talk
I'll let you in on a little secret... there is one question that is the most important, the most crucial, and the most overlooked question of all, overlooked by even the most seasoned investors... wait for it... okay, I'm sorry, but here it is:
You need to ask yourself "Do you even want the rental property regardless of how good the numbers are?" Do you want it? It's such a simple question that most of us overlook its importance. You will have to deal with the property long after the closing, manage it, and deal with any issues that arise later down the road, the good and the bad. Is this investment property worth your time?
"Do you want it? It's such a simple question that most of us overlook
its importance."
Phase 1: How to Use Sales Comparisons and Cap Rates in Rental Property Analysis
Well, I'm glad you decided it's worth it because, truth be told, real estate investing is a powerful wealth-building tool like no other, with benefits that can supersede all other investments when done correctly... now back to the numbers.
When running the numbers on an investment property, you should be looking for positive cash flow rental properties and equity opportunities, either through the purchase price or value-add real estate strategies such as those mentioned in Forbe's Multifamily Investment Strategy.
If the property is between 1-4 rental units, look at the area comps to determine its value. Aim to acquire the property with at least 20% built-in equity. However, equity is rarely just sitting there for the taking—you often create it through strategic improvements such as adding a bedroom, a garage, or key renovations. If the property is 5+ units, check the cap rate for real estate investments in the area to ensure the purchase price aligns with the market.
Phase 2: How to Evaluate Rental Comparisons for Investment Properties
Rent comparables, or 'comps,' are crucial for determining rental income. Unlike property sales, where the MLS is preferred, rental comps are best found on open-source rental listing platforms like Zillow and Realtor.com. These provide a more accurate picture of the rental market trends, as much of the rental market doesn’t rely on realtors. Ensure you examine similar properties and units, and understand what items are included in the monthly rent of comparable options. Are utilities covered by the owner? Is the rent listed as high due to a promotion?
Phase 3: Analyzing Rental Property Income and Expenses for Maximum ROI
To begin effectively, request a property's financials, history, and disclosures. For properties with 1-4 units, financial records may not be available. For properties with 5 or more units, routinely ask for the profit and loss statements, rent roll, and 'T12-24' as these properties depend on net operating income for valuation.
Rental Property Income: Evaluate expected rental cash flow by analyzing market rental comps and reviewing the property’s financials. Look for additional income sources like laundry facilities, parking fees, and storage units.
Property Taxes: When calculating income and expenses, consider post-purchase tax increases. Check with your local tax assessor or visit the county’s website to estimate current and future tax obligations.
Insurance Costs: Insurance is a significant expense. Get rental property insurance quotes from local carriers such as Liberty Mutual or Allstate or really any other reputable carrier, early in your analysis. Once you gain experience, you’ll be able to estimate costs without calling insurers for every property.
CapEx and Maintenance: Distinguish between maintenance (day-to-day repairs) and capital expenditures (CapEx) like roof replacements or HVAC upgrades. Budget 5-10% of gross rents for both, adjusting based on the property class (A, B, C, or D).
Vacancy Costs: Factor in vacancies due to tenant turnover, repairs, or evictions. Estimate 2-5% vacancy for 1-4 unit properties and 5-8% for 5+ unit properties without rental history. If history is available, analyze actual rent received versus scheduled rent.
Other expenses to factor in include HOA dues, waste collection, snow and lawn maintenance, utilities, advertising, legal expenses, and property management.
Final Rental Property Investment Breakdown
You did your homework and got all the right numbers, but what does all this madness mean? Well, let's put the numbers into context by using them to determine some basic rental property investment metrics such as the NOI, Cash-flow, and ROI.
NOI (Net Operating Income): NOI = Total Income - Operating Expenses (excluding mortgage payments). Essential for multi-family property valuation.
Cash-Flow: The rental property cash flow formula is: Income - All Expenses (including mortgage payments). Positive cash flow rental properties generate steady income
ROI (Return on Investment): ROI is a key metric to compare real estate investments to other assets. Formula: Annual Cash Flow ÷ Total Out-of-Pocket Expenses (down payment, closing costs, and repairs).
Final Thoughts
We've covered the three phases of a investment property analysis...now in addition to those, you should consider conducting three separate analyses for each property that you deem purchase-worthy
Seller's Numbers: Understand how the seller/broker presents the deal, usually it's in a pro forma format similar to what RealWealth.com explains here. If it looks bad at this stage, move on.
Your Standard Investment Criteria: Adjust the numbers using your minimum and maximum thresholds for cash flow, CapEx, and vacancy rates.
Value-Add Analysis: Assess the potential ROI from increasing rents, adding amenities, or making strategic renovations.
Why three? The seller’s analysis often paints an overly optimistic picture. Your analysis provides a realistic snapshot based on your investment strategy. The value-add analysis helps determine if there's room for upside, but don't rely solely on potential improvements to justify a deal.
Analyzing a rental property takes time at first, but with practice, it should take only 10-15 minutes per property. If you need assistance, G3 Management offers a free rental property analyzer tool. As you refine your skills, you’ll identify whether a rental property is overpriced, under-rented, or a true investment gem.
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About the Author Ricardo Reis - Learn About Ricardo
Entrepreneur, Inventor, Investor, Military Veteran. Ricardo is a member of G3 Management & Investments a division of Great Lakes Real Estate and a real estate professional. He is a real estate professional and a successful real estate investor for over 15 years.
NOT INVESTMENT, FINANCIAL, LEGAL, TAX, OR OTHER ADVICE: This blog is for informational purposes only and not a substitute for professional advice. We do not offer advice, solicitation, recommendations, or endorsements. You are solely responsible for evaluating the information's merits and risks. Always consult a qualified professional before acting.