How to Evaluate a Rental Property Investment

Owning and operating rental property is a time-honored strategy toward building generational wealth. Not to mention a wise—and passive!—diversification of income-producing assets. But, savvy investors should evaluate rental property opportunities thoroughly to ensure they provide value over time.

It’s all too easy to fall prey to seductive whispers of undervalued homes that are ripe for flipping. Understandably, the promise of passive income appeals to those looking to begin investing in real estate. But, without proper planning and financial knowledge, you can find yourself underwater down the road with a home you can’t afford. 

Start Your Property Search

A smart investment begins with solid research—especially if you’re not familiar with some essential real estate terminology. It’s usually best to gain at least a little background knowledge beforehand. 

Take these three simple steps to ensure success in your rental property search: 

#1: Learn the Local Market

Especially if you’re an out-of-town investor, you should spend time getting to know the neighborhood(s) where you plan to invest. Neighborhoods are often a source of local identity and pride. So, busting in with an agenda and strict timeline can be alienating to your neighbors. If you happen to be looking in the Dallas-Fort Worth area of North Texas, we’ve got an overview of neighborhoods you don’t want to miss. 

Learn the local market by researching on your own, with a friend who lives locally, or with a property manager that has insider expertise on where to invest in your area. 

#2: Gauge Your Price Range

You may have heard the advice, “Buy the cheapest house in the nicest neighborhood you can afford.” While this advice isn’t necessarily wrong, it’s certainly outdated. The idea of “what you can afford” is a personal decision more than anything else. It’s much more than asking, “How much will the bank loan me?” Only you know how much you’re willing to go into debt or the risk you’re willing to assume. Luckily, there are a few tried-and-true ways to calculate a wise investment amount.  

#3: Learn Your Type of Investment

There are many ways to invest in real estate, from single-family homes to multifamily units to commercial properties. Beyond the property type, there are other decisions to consider. How will you profit from your new property—through a long-term lease, vacation rental agreement, or by flipping the house for a profit within 12 months? You can also buy land, or real estate stock for a truly passive income. Determining the type of investment(s) you’re interested in is paramount before spending a dime. 

Compare Rental Properties

Once you understand the local market, have a grasp on how much you’re willing to spend and know what type of investment you’re looking for, it’s time to enter the arena. With an idea of what you’re seeking, you’re finally ready to shop for properties. 

Many investors begin by comparing similar properties in different neighborhoods over time. When trends start to appear or you spot a good deal backed up by your market research—it’s time to act. 

Throughout this process, keep in mind that every real estate market is unique. See if there are any trends you can spot locally that may affect the market in the upcoming months or years. Are any new jobs coming to town or are companies moving locations? See if you can put your local knowledge to use in making your advantage. 

Of course, there are faster and easier ways to build investment expertise. Finding the right property for you can be an exhausting and difficult process on your own. Many investors prefer to work with a property manager who can offer expert insight into local and even distant markets if you’re investing remotely. 

Income vs. Cost Approach

There are two distinct ways to approach your real estate investment: the income approach and the cost approach. 

The income approach first asks, “How much money can I make from this real estate investment?” Meanwhile, the cost approach begins by asking, “How much money do I need out of pocket?” The income-focused buyer is focused solely on the end game and opportunity offered by a property. By comparison, the cost-focused investor sees today’s reality clearly by focusing on how much monetary risk is wise to take on. 

Successful real estate investors don’t land fully on either side of this dichotomy. Instead, they take both into consideration and answer the question, “How much house can I afford?” by calculating the risks they can manage with the rent they can garner.

Estimate the Return on Your Rental Investment

Another way to test whether an investment is sound is by calculating the capitalization rate, also known as a cap rate. The cap rate helps determine the rate of return expected compared to alternative investments. 

First, calculate net operating income to determine the cap rate, which is the expected annual income from rentals minus costs for taxes and maintenance. When estimating the expected income from rentals, be conservative; there are likely to be periods of vacancy between tenants. Then, divide the net operating income by the current market value of the home.

This will help you quantify the expected ROI of any rental property investment.

Whether you’re a veteran real estate investor or new to the game, there are many factors to consider when embarking on a new venture. 

Especially for those starting out, partnering with a property manager provides massive value. With minimal effort on your part, you’ll gain expertise, efficient management, and streamlined maintenance, all while helping you avoid money pits and costly renovations. But those reasons only scratch the surface of the ways a property manager could benefit your business. 

No matter what kind of property you want to invest in or which local markets you’re looking at, success comes down to a bit of patience, doing your research, and choosing the right partners along the way.