A rental property may look good, but knowing if it will help you hit your financial goals? That’s a whole different story. When it comes to rental property analysis, it can be confusing and intimidating if you don’t know what to look for. This guide will walk you through everything you need to know about performing an investment property analysis—from setting expectations for your potential return on investment (ROI) to understanding how local market conditions affect your ROI projection.
What is Rental Property Analysis?
Rental property analysis is the process of determining the potential profitability and risk of a rental property. It’s an integral part of any investment and should be done before buying any rental or investment property.
The Components of Investment Property Analysis
It’s important to understand that not all properties are created equal. Therefore, when analyzing a potential real estate deal, you’ll want to look at these factors before you get too emotionally invested in the property or area.
Upfront Costs
Upfront costs are the expenses that are necessary to close on a rental property. Most investors only factor in basic things like down payments and closing costs, but this can include much more than that. Upfront costs include:
- Down payment
- Closing costs
- Loan points (to lower your interest rate)
- LLC formation and legal fees
- Initial repairs to get the property rent-ready
- Renovation and rehab costs
- Buyer credits (if necessary)
Income
Income is what you expect to be receiving from the property every month. Income is NOT limited to just rent payments. Income includes:
- Rent
- Late fees
- Pet fees
- Laundry income
- Utility payments
- Solar income (if selling back to the grid)
Expenses
Expenses can make or break your rental property investment. Don’t simply think that because you owe your mortgage, taxes, and insurance, you ONLY need to pay for those things. Other expenses include:
- Mortgage
- Property taxes
- Property insurance
- Utilities (if paying for all/any)
- Maintenance and repairs
- Capital expenditures (replacing a BIG item like a roof)
- Continues legal costs (LLCs, umbrella insurance, etc.)
- Snow plowing (if in a northern state)
How to Analyze a Rental Property in 6 Steps
Now you know a rental property’s upfront costs, income, and expenses. You’re ready to check out some deals! The following six steps are designed to help you make an informed decision about buying a rental property:
Step 1: Evaluate the Neighborhood
Knowing your neighborhood, especially if you’re investing out-of-state, is crucial for a real estate investor. You’ll want to ensure you’re buying in an area with low crime, good schools, public transportation, clean streets, low taxes, appreciating houses, and landlord-friendly laws. But, of course, getting all of those perks would be phenomenal, so look for markets that will help, not hinder, your real estate investment.
Don’t know which states are best for investing? Check out our article on the Best States to Buy Rental Property.
Step 2: Determine the Market Value of the Property
Now you know where to invest, it’s time to figure out what a property is worth. If you’ve settled on a three bedroom, two bathroom, 1,000 – 1,500 sq ft house, then start looking for homes that fit those requirements and see what they have sold for in your market. This pricing scale will fluctuate, so consider the differences in homes with recent renovations, new paint, additions like solar panels, etc. Get a feel for how much a home in your area should cost, so you won’t be overpaying when you come to closing.
Step 3: Calculate the Cost of Owning the Rental
Now it’s time to figure out how much the rental property will cost to hold. This number is CRUCIAL because it will allow you to see if the property can profit in your market. Add up the estimated mortgage, taxes, insurance, property management fees (usually around 10% of rent), HOA fees, repairs (generally around 5%-10% of rent), vacancy rate (8% is standard, but check on your local market stats), and any other expenses you can predict.
Remember to add up your cost to close, which would include your down payment, closing costs, repair expenses, mortgage points, and more.
Step 4: Factor in Any Repairs or Rehab Projects Needed
If you are performing a renovation on a home, build out a scope of work as detailed as possible. Reach out to local contractors and ask how much these repairs or renovations would cost. If it’s going to be tens of thousands more out of pocket, you’ll want to know before you close.
Step 5: Estimate Market Rent
Now you know how much it will cost to get into a property, the next step is determining how much the property will bring in. You can use tools like Rentometer, BiggerPockets’ rent estimator, or Zillow’s rent estimate calculator to understand how much your property could rent.
Run these tools but ALSO check the local live rental prices for that area.
Step 6: Calculate Your ROI
Lastly, you’ll need to know how to calculate ROI on rental property. This formula is simple, but it’ll quickly help you determine whether a rental is worth the investment.
ROI = Annual Profit / Acquisition Cost
Let’s say your rental property will make you $300 per month. That’s $3,600 per year! But, you’ll also pay off $3,600 of principal from your loan every year, AND your house appreciates (on average) by $6,000 per year. You bought the home for $300,000 with $10,000 in closing costs.
Profit = $3,600 (rent-expenses) + $3,600 (principal paydown) + $6,000 (appreciation) = $13,200
Now take that profit and divide it by your acquisition cost ($300,000 + $10,000)
ROI = $13,200 / $310,000 = 4.25% ROI
That’s not a high ROI for some investors. So it might be time to reevaluate your offer OR look for other rental properties.
5 Metrics to Use for Your Rental Property Analysis
There are a few metrics you can use to determine the value of your rental property before buying. These include:
Cash Flow
Cash flow is the gold standard of rental property analysis calculations. It tells you how much you’ll profit monthly from owning the rental property. Cash flow is THE calculation to pay attention to if you’re trying to hit financial freedom through real estate investing.
How to Calculate Cash Flow
Cash Flow = Total Income – Total Expenses
IRR (Internal Rate of Return)
IRR (internal rate of return) is an exceedingly helpful calculation for rental property investors. It tells you how much annualized return you can expect from a property over its ENTIRE holding period. In addition, this calculation often illuminates why some negative cash-flow properties are still worth buying.
How to Calculate IRR
This is a complex calculation, but some online rental property calculators can help you calculate IRR, even if you’re not so skilled mathematically.
Cash on Cash Return
Cash on cash return is one of the most popular calculations for investment properties. It tells you exactly how much of your money is being returned annually after investing. Unlike ROI, cash on cash only factors in the money you’ve put into the deal, not how much the property costs overall.
How to Calculate Cash on Cash Return
Cash on Cash Return = Annual Net Cash Flow (Profit) / Total Invested Cash
Return on Equity (ROE)
Return on equity gives investors a complete picture of how much their rental property returns will be. It includes cash flow, equity, and appreciation, so you see the overall benefit of your investment. It also helps you compare two properties against each other when you’re thinking about selling one rental to buy another.
How to Calculate ROE
ROE = Total Annual Return (Cash Flow + Appreciation + Principal Paydown) / Total Equity in the Property
Gross Rent Multiplier (GRM)
Gross rent multiplier (GRM) gives you a quick glance at how much a property will repay itself yearly. This calculation can be done in seconds and should be used as a prequalifying calculation when quickly analyzing potential properties.
How to Calculate GRM
GRM = Purchase Price of a Property/Gross Annual Income (Total Rents)
Run a Rental Property Analysis BEFORE You Buy
These steps can take hours, but the investment is worth it. Not only will you better understand what’s going on with your property, but you can also use this information to make better decisions about how to manage a rental property in the future.
However, if math isn’t your strong suit or you don’t want to spend hours crunching numbers then you can opt to use a property analysis software like DealCheck. Whichever option you choose, albeit manual or via an investment analysis tool, as you analyze each metric, consider potential ways to improve your numbers or give them context, like if one month shows a higher turnover rate than usual due to seasonal factors such as weather conditions or holidays. This is a property, not just a number on a screen!
And remember: it doesn’t matter if you have zero experience with real estate investing! Anyone can do these calculations; before long, you’ll be doing them in seconds!
Investment Property Analysis FAQs
Now you know how to analyze a rental property. Still looking for more context before you crunch the numbers? Check out these common FAQs:
The simplest way to analyze a rental property is by taking the expected income and subtracting the expected expenses. This will give you your monthly cash flow, one of the investors’ most common metrics when analyzing properties.
Using gross rent multiplier (GRM) is one of the fastest ways to analyze a rental property. Simply divide the annual rent by the purchase price of the property. Remember, the lower the GRM, the quicker it will take to pay off the property (in theory).
A rental property analysis usually includes a few key factors: rental income, expenses, principal paydown, appreciation, and sometimes tax benefits. All these factors can be calculated BEFORE you purchase the property, so you won’t go blind when investing in real estate.
