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Rental properties and real estate can be a very beneficial investment that can make sense in many scenarios. Real estate provides you with the benefit of stability, a monthly income through the rent it generates, and has also provided many investors most recently with strong returns on their investment as prices have risen across the country. However, there are many variables that you should consider when thinking about investing in a rental property, and which properties may be a good investment for you or which ones may be a bad investment.
The location of a rental property is a key factor in determining if a property will be a good investment or not. Remember, the location of a property is the only thing that cannot be changed when it is purchased. If the property is located in a city or urban market with population growth and a steady economy, it will help your property to retain its value, and will make it much easier to find tenants to rent it out to. Especially if the location is up-and-coming and has plenty of demand from renters, this may make it easier to raise rents as your tenants turnover. Other factors that may go into determining if the property has a good location to rent or not include:
- The crime rate in the area,
- Schools in the district,
- Proximity to amenities, and
- The number of other listings on the market in the area, and their average rents
All of these factors can be helpful parts in your assessment criteria related to location, and should be considered. Aside from the value of the location to renters, having a rental property within a reasonable proximity to your home can make it much easier to manage and maintain, especially if you don’t plan on hiring a property manager.
The Price You Pay for It
Even if the building and location tick all the boxes and have the potential to be a good investment for you, the price you pay will determine if it is or not.
One of the main ways that real estate investors value a property is through the net operating income (NOI) it generates, which is very useful for determining the return on investment you can expect. This method is especially useful when a property is being purchased with some form of loan attached to it, with interest expenses. This is because your return on investment is your revenue from the property minus your expenses, which includes your interest payments, divided by your purchase price. If you have a very expensive purchase price without a similar uptick in the net operating income the property brings in, it will mean lower returns. A rental property calculator can be a helpful tool when determining if the price you are paying for a property is fair or too high.
The second main way real estate investors value a property is through a ratio called a cap rate. This ratio is used to determine the annual returns that a property will give you without considering interest expenses. If a rental property is very attractive and likewise being priced as such, it can lead to the return on investment in other asset classes such as stocks being higher.
Your Risk Tolerance
With better quality rental properties usually being priced higher, this may make for a tradeoff that you have to make between buying a very good quality property at an expensive price and low cap rate, versus buying a property that needs improvement at a lower price and higher cap rate. If you have a higher risk tolerance, you may be more comfortable making a purchase in a struggling market and hoping for a turnaround, versus buying in a market with stronger growth fundamentals and a higher price associated with it. As well, how you find the property is important to consider with your risk tolerance. For those more conservative, you will likely want to fund it with a smaller mortgage loan and more equity, versus those with a higher risk tolerance, who are comfortable taking on a larger loan on the property with less equity, in order to generate higher returns.
Age of the Property
The age of the property will be correlated with how risky it is, considering the added maintenance and repairs that may be required. This means that it’s important for real estate investors to be compensated for this added element of risk, through a higher entry cap rate. This higher entry cap rate will mean a higher margin of safety should anything go wrong or costly repairs be needed, and should be considered along with your risk tolerance. For rental property investors looking for a safer option, buying a newer built property may be a better option, even with a lower potential return being the cost for the added level of safety and comfort.
When trying to determine what is the best course of action in your situation, and whether that is to search for a rental property or not, it’s always crucial to think personally about your needs. Whether that be what type of returns on investment you may need for the added headache, to how you would manage a property, coming to a conclusion that is the right fit for you is the most important factor in determining what you should consider in a rental property.