How to Analyze a Rental Property to Know if it Will ACTUALLY Produce Income
Ultimately, if you are buying a rental property, what is your reason for doing so? Let me guess — income. Right? Has to be. Why else buy a rental property?
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What a lot of people don’t realize is what actually contributes to a rental property creating income. I mean, obviously tenants pay rent, and you pay your expenses from that and pocket the rest (assuming what you are collecting covers the expenses), but I would argue there is way more to the equation than meets the blind eye.
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Required Analyses if You Want Profit From a Rental Property
If your goal is to create income for yourself by investing in a rental property, I believe there are two non-negotiable factors you have to look at in order to actually ever see income.
- Risk Factors
Wait, what? You mean I don’t automatically profit by just owning a rental property? No. Shocker, I know, because most of us grew up believing that was true.
Here’s what school did not teach us about what makes a profitable rental property:
Please, people, learn the math. Even I almost got duped into buying some rental properties when I first started out that never would have actually given me any profit, all because I didn’t know running numbers was even a thing. Again, if you just own a rental property you automatically profit, right? No!
There are a few different income streams available with rental properties, but most of your income will come either from monthly cash flow or appreciation (or a combo of both). There are others, like tax benefits, but income tax benefits alone won’t necessarily put you into the positive for profits. Cash flow and appreciation, however, can.
The term monthly cash flow refers to any money that you pocket each month after the rent is collected and all of your expenses are paid out. Anything left over after that? Income, also known as “cash flow.” If done right, cash flow can become very profitable.
For example, if my projections hold true on one of my properties, what I invested into that property should come back to me in full via monthly cash flow in only 5.5 years. Any money after that each month is free money in my pocket! That’s not bad at all.
There is a lot that goes into whether or not my projections will hold true, but don’t worry, I’ll get to that. The trick to cash flow is to have several properties that can net you whatever amount of monthly income you want to achieve. Get enough of those bad boys and the monthly cash flow is truly passive income, and you start freeing yourself up financially! To make sure you understand how to calculate the projected cash flow on a property and determine the cash flow returns, check out “Rental Properties So Easy You Can Calculate Them on a Napkin.”
This can happen on a cash-flowing property as well, but some people intentionally buy properties even if they don’t have cash flow just because there is a chance for appreciation. Appreciation is basically when the value of a property goes up, either because the market’s value itself went up, a property was rehabbed significantly enough to trigger appreciation, or just because of general inflation. Some markets appreciate drastically more than others, and you must know that appreciation is purely speculative (ask all the home owners in 2009 what they think about speculation) so there are no guarantees.
Investing for appreciation is often riskier than investing for cash flow, so be aware of that. There are methods to being successful in investing for appreciation. I can’t speak to them because I don’t invest for appreciation, but in terms of numbers, make sure you know what the numbers really are and how much appreciation would be required to make a profit. If you buy a property for cash, then that’s another story. But what if you buy a property with a mortgage? Don’t forget in that case you’d be needing to make up for what you paid out in interest, in addition to what you put into the house, to make a profit.
A lot of people don’t realize that just because a property sells for a lot more than they bought it, that doesn’t always mean they actually made anything on it. So be sure you know all of the numbers in terms of stats and trends so you can, to the best of your ability, predict possible appreciation as accurately as possible, but then also know how to do the math to ensure you really will be coming out in the black if you do get the appreciation. Lastly, make sure you know how to run cash flow numbers even if the property you are looking at won’t cash flow because you need to be fully aware of how much money you could potentially be losing each month in expenses while you wait for the appreciation.
Now, about all of the numbers — here’s something a lot of people don’t realize. You can project both cash flow numbers and appreciation numbers until the cows come home, but unless you are deeply considering several other factors that may affect those numbers, you may never see your projection ever again once you own the property.
When you are shopping for a potential rental property, you can be as accurate as possible with your numbers by considering ALL expenses, using actual numbers rather than estimates, being conservative with any estimates you use (which should be minimal, but they do exist), and only buying a property that suggests a good bit of margin (i.e. don’t buy a property for cash flow that is estimated to provide only $50/month of cash flow).
But then, despite your best efforts, something unknown and unexpected flies up, smacks you in the face, and blows all of your profit out of the water. Ah! I bet you hadn’t thought about what those things might be! Well, maybe you have to some degree. Obviously, if a tenant destroys your property, that might cost you a good bit — we all know that one.
But what are other factors with rental properties that you should always consider when it comes to rental properties? Meaning, the factors that could throw every estimate you ever came up with down the toilet and put you into the red on your income sheet.
The items I am including in this list are things that can somehow cost you, as a rental property owner, money. Costing you money is important because, well, the whole point of investing is to not lose money.
OK, here’s a brief list of things you should always consider when looking at a rental property! We’ll call them “potential red flags.” I’ll go through each one, but realize that a lot of these dovetail together to some extent.
7 Property Factors to Examine for Potential Red Flags
Huge risk here, in the sense of the possibility of underestimating repair or rehab costs. One massive expense in this department that wasn’t expected can quickly put you in the hole. You should always have a thorough professional property inspection completed on the house, and even then there could still be some overlooked items. So always make sure you go out of your way to confirm the condition of the property you are prospecting!
Yes, be able to calculate all of the appropriate numbers to ensure you are expected to gain a profit from your property, but in terms of numbers as a risk factor — things like whether or not the projected rental amount is realistic or stays realistic or not — are things you need to look at. These can’t always be known exactly, but do some due diligence to confirm to the best of your ability how realistic the numbers you are using are, and if they will stay as is. Maybe even play with some worst-case scenarios on these.
Exit strategy refers to the long-term plan for a property — things like selling the property or continuing to rent it out, or basically, what do you plan to do with it down the line? Will the property be sellable for a decent price later? Or if you want to just rent it out forever and ever, will you be able to actually do that? If the answer is “no” to either of those, your bottom line may be affected quite severely.
I hold strong in the idea that few things are more costly to a rental property owner than bad tenants. The minute you have a bad tenant, you could be looking at things like non-payment of rent, eviction costs, damages, and even stolen appliances or cut lines. I’ve been there and done that with bad tenants, and they absolutely ate me alive.
So always consider where you are buying and what kind of tenant pool that area will, generally, offer you. There’s exception to every pool, but consider the risk factor of the tenant pool you are dealing with. No projected cash flow numbers can compete with horrible tenants.
These can happen because of bad tenants, or maybe you have a situation of a saturated market where there are so many rental properties available to renters that you just can’t land a good tenant for a while. If you paid cash for your property, then vacancies aren’t as detrimental, but if you are paying for a mortgage and the other expenses while the property sits vacant, that can add up quickly. Minimizing vacancies is crucial for a rental property owner.
If a market has either a declining population, little industry, or a decrease in the numbers of jobs, not only can the value of your rental property drop dramatically, but the tenant pool of who you can rent to may likely decrease and/or becoming a much lower quality, the vacancy rate may become higher, and overall, your exit strategy options may become limited. All very costly.
More specific than the market itself, the location of a rental property down to the street and neighborhood it is located in can directly affect the tenant quality options, the vacancy rates, and the exit strategy. All of which you already know can directly affect your bottom line.
Always consider each of these items when looking at a rental property. You may not, or you may not be able to, have concrete support data for each item to know exactly how it will pan out, but having a general knowledge of each at a minimum is fairly crucial if you ever want to see your bottom line.
A last note to finish up this discussion: If you buy a property that has a lot of risk items attached to it, that’s not necessarily a deal-breaker. There are a lot of successful investors who specialize in “high-risk” properties (such as high-risk tenants and properties in bad conditions and sketchy areas). But if you are tempted to go this route, understand that there is a lot that goes into how to make those kinds of properties successful, so you can’t just go into it all willy-nilly thinking it will be sunshine and roses.
No, you need more education on how to run those types of properties. If you are more risk-averse and not really interested in wearing a football helmet and a revolver on your belt when you visit your properties, then minimize each of the risk factors listed above. Buy in nicer areas that attract nicer tenants and where the properties are nice and in good condition and in a growing solid market. Doing so will better secure a long-term relationship with your initial profit projections.
Any seasoned investors out there buy properties that had some unknown risk factor attached to it that you weren’t aware of beforehand? What was it and how did it affect your numbers?
Let me know with a comment!