Analyzing Rental Properties for Potential
So you want to invest in rental properties huh?
I bet you’re looking for that cash cow that brings you in fat monthly checks and never gives you any issues right?
Well before we can get there, we need to figure out what a potential cash cow property can rent for to see if it’s even possible.
How do we do that?
We look at similar properties on the same street or in the neighborhood and see what rents those properties are getting from their tenants. This is known as pulling “rental comps”.
You can pull them yourself or speak with a realtor and have them pull comps for you on a prospective investment property.
Think like the renter would for a second here. If you’re shopping a neighborhood to potentially move into you are likely looking for nearby schools for your kids, low crime rates, and a decently affordable rent depending on what your salary is.
If several properties on the same street are listed for rent you’re going to go see each of them and compare them. You’ll be looking to see what amenities they have, what level of finish (how nicely updated they are), as well as other factors.
Back to landlord mode.
As a landlord, if you are competing with other landlords on the block, you have to know what they are offering in order to justify the price they are charging. This information will help you decide what you can reasonably charge on your property to compete for tenants looking for a place to live.
Make sense? Great let’s dive in.
How to Determine What My Rental Can Rent For?
Step 1: Gather Your Information
Before you can do any analyzing you need to gather information and data of the rental property in order to understand the risks, cash flow, return, and the outlook of the future for this investment.
Financial analysis involves inputting data into a model and it spits out a bunch of financial information that you can then use to determine if the investment is a good deal or not. You’ll need the following information:
Details of the Property: Year built, how many units, square footage, utility metering design, the age and condition of mechanicals (furnace, water heater, electrical, plumbing, and roof), etc.
Where to find it: Most county recorder offices have this information and now days you can find it online. Sites like Zillow even give fairly accurate public records information when you type in a property address. Utility meter design will be something you go look at. Apartments that are individually metered are good because each tenant pays their own bill while a single meter means that you foot the bill and get reimbursed by each tenant by charging it in your rent.
Purchase Information: purchase price/asking price, closing costs, estimated repair costs, etc.
Where to find it: The seller will have the asking price obviously but closing costs you’ll estimate (2-5% of purchase price) and repair estimates you’ll have to get by doing an inspection and bringing along a general contractor who can run estimates for you if you don’t know how to estimate yourself. I wrote a book though to help you learn how to estimate repair costs that you can check out via this link.
Financing Information: everything you need to know relating to the loan you are obtaining to make the purchase with. This will include total loan amount, how much you are down paying, interest rate, loan origination costs, and how much your monthly payments will be for principal and interest.
Where to find it: Talk to your lender and get this information from them. You can also use online mortgage calculators to estimate possible loan scenarios.
Property Income: what income the property produces. If there are multiple units, you’ll get a rent roll showing what each unit is being charged since some have different beds/baths/square footage you can charge different rent amounts.
Where to find it: The seller should provide you with records
Property Expenses: what all the detailed operating expenses are. Expenses typically include property taxes, property insurance, maintenance, repairs, property management, etc.
Where to find it: The seller should provide records but you’ll have to estimate some as well.
Further Discussion on Income:
What if you’re buying a single family home that was owned by a homeowner instead of being used as a rental? How will you determine the rent you can charge for the home?
To do so you need to know the features of your property. The features of your property will be most important for starting out and determining a rental price to charge to begin with and then the economy and rental market we discussed above will affect future years whether or not you can raise rents to grow your income and cash flow.
So what are features of a single family home?
Well these would be things like how many bedrooms, how many bathrooms, how big is the home in terms of square footage, what year was it built, and is it one, two or three stories?
Common knowledge rule of thumb is that the more bedrooms and bathrooms a property has the more you can charge for rent for comparable properties. You’ll also look at square footage because larger homes rent for more than smaller homes. Duh, right?
Once you know the features of your home you can get comparable rents from nearby properties that have similar features. If you have a 3 bed and 2 bathroom home that is 1,500 square feet, then you’ll want to look for nearby homes that are for rent that are also 3 bed, 2 bath, and around 1,500 square feet.
How do you research rents of similar properties?
Call around to local “for rent” signs you see
Pretend to be a tenant gathering information about a property you want to rent and ask the landlord different questions such as how much rent is, how many beds and baths, do they allow pets or smoking, and any additional features of the property. Try to find properties close by to yours, maybe down the road or on nearby streets that are for rent because these will be your competitors and you’ll get a feel for how they’re pricing their asset.
You can go onto Zillow and look up not only properties for sale but also properties for rent. I’ve created a tutorial video on how to use Zillow that you can watch by clicking the following link below.
How to Use Zillow to Analyze Properties for Rent
Zillow allows you to set criteria to narrow your search results, so you’ll want to enter the number of bedrooms and bathrooms and square footage of your property for starters, and then you can decide how narrow you want your search to get. I’d start with just those 3 criteria and then zoom in on the map to the area around your property to see if there are any houses that show up nearby that are for rent. Whatever they are renting for can give you an idea of what yours may rent for. You can then call to see if there are any features differentiating their property from yours that would allow you to charge more or less.
List your property for rent and then get a feel based on number of applicants
This will be the most realistic way to determine what your property can rent for but the first two steps will help give you a ball park price to start your listing at. Once you’ve listed your property for rent, gauge how many calls you get. If you’re flooded with phone calls of interested applicants, you may be charging too low of rent and if you’re phone is silent you may be overpriced. Let the market tell you based on the activity your listing gets.
Wrapping Up the Income Discussion
Once you’ve determined the rent that you can charge per month for your property, you can multiply it by 12 to get the annual rent you’ll earn provided there are no vacancies.
Vacancies are what we will wrap up this discussion with though. When you own an investment property, you have to account for vacancy. Beginning investors will be overly optimistic and think that their investments will never sit vacant. Therefore, they’ll plug in a full 12 months rental income on the pro forma when projecting out their net income.
I always run 3 different pro forma spreadsheets when analyzing an investment. I create an optimistic pro forma where I use 0% for vacancy. Then I create a realistic pro forma where I include 1 to 2 months of vacancy expense. Finally, the third pro forma is a worst-case/conservative approach where I use 50% vacancy rate, assuming the single family home will sit empty for 6 months.
This allows you to get 3 different cash flow projections based on how the economy/rental market may go.
Assume the optimistic case is when demand is hot and there are no vacancies as everyone is trying to find a place to rent at an affordable price. Assume the realistic model to be for a stable market when rent prices and the economy are modestly growing and you’ll have tenants move out from time to time. Finally, assume the conservative model to be an economy where housing supply is abundant compared to tenant demand for space to live.
Or maybe this is a time in the economy where people are unemployed and can’t afford the rents your area is charging, limiting the pool of applicants available and causing long vacancy periods. Who knows? Or maybe your property undergoes renovations and they take 6 months leaving your property vacant during that period.
Overall, the lesson to close out this discussion is to include the full 12 months rental income in the rent income but have a row underneath for vacancy expenses that subtracts out a month or two in vacancy to get a gross income that is realistic. Then create two other pro forma sheets for 0% vacancy and 50% vacancy and analyze what the cash flows would be for each after your operating expenses.
Your model is only as good as the information that you put into it. The better information you can gather, the better or more accurate your output information will be.
Important Note: Seller’s want to make their information look better than it really is in order to sell their property for more value. Be wary of this when getting your information because the actual data may differ than what the seller tries to fake or fluff up. Ask to see actual data such as previous year’s tax bills and tax returns, maintenance records, etc. Apartment owners should have accounting software in place that their property manager is using and can print out accurate Profit and Loss statements. Other investors won’t keep good records making information hard to gather other than income tax returns.
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