Opinions expressed by Entrepreneur contributors are their own.
Wondering how to evaluate an investment in real estate? Investing can be tricky in any industry, but when considering acquiring a rental property, you need to be prepared for any unexpected expenses and fees that arise.
The best way to make money in real estate is by managing your expenses through careful preparation, allowing yourself to maximize profit. Here are three tips for determining whether your investment property will be profitable.
Related: The Top 6 Factors Affecting Investment Property Value
1. Use comparable properties to determine profitable pricing
One of the most important investment property tips is learning appropriate pricing. What is an acceptable purchase price for your potential acquisition, and once you purchase it, what rent rate do you need to set in order to generate adequate profit?
The best way to determine appropriate pricing is by using comparable properties, or comps. Investors use properties similar in size, condition, amenities and number of bedrooms within the same neighborhood to determine the investment’s viability. If you are looking to purchase a home that is substantially more expensive than comps within the area, that could be a sign that you have negotiation leverage or that you should start looking for a better deal with a different property. Remember that the purchase price matters when thinking about your Return on Investment (ROI) — the lower your purchase price is, you can generally expect more profit potential.
You can also use comps to figure out how to price your rental. Potential tenants are most likely conducting their own market analysis, and if they see that your rental is asking for much more than nearby comparable properties, chances are they will not be interested in filling your vacancy. High vacancy rates are a major profitability killer, so price your properties appropriately to lessen vacancy rates as much as possible.
Conduct a sales comparison, or a price-per-square-foot approach, to conduct your comparable property research. Find properties sold within the last 30 days that are similar to your property, then calculate their asking price per square foot. Once you calculate your own price-per-square-foot, you can see how you stack up against the local market.
2. Calculate expected net operating income and cap rate
When wondering what to look for in an investment property, expected Net Operating Income (NOI) and capitalization rate, or cap rate, are two metrics that are essential to consider. These two calculations will let you know how profitable you can expect your investment to be.
NOI is the overall income that your property generates minus regular operating expenses. Your cap rate is your NOI minus the original price you paid for the property. When you calculate these numbers, you will be able to determine how quickly you can make back what you spent on your real estate investment and start making a profit. A higher cap rate means higher returns, more revenue and generally a more successful investment.
It’s a good idea to calculate these metrics prior to purchasing your property to determine whether the purchase is a strong investment decision. However, since you’ll be calculating these numbers prior to the actual purchase, some numbers like rental rate and total expected income will be approximated, and your results could potentially be skewed.
Related: Smart Investors Know These 5 Rental Property Secrets
3. Perform a risk analysis
While any investment involves risk, real estate investments are known for their volatility due to the unknown risks that come with home buying. Maintenance problems, macroeconomic issues, zoning challenges and other potential money pits greatly affect your rental property’s potential profitability and the overall success of your investment.
The best way to prepare for these inevitable hang-ups is to plan for them. Perform a risk analysis before you purchase your property, considering the following factors. Keep in mind that this list is not exhaustive — continue to do your own research into what kinds of problems investors in your area are running into and prepare for those as well.
Employment rates: What is the overall health of employment in your area? While some towns experience a boom in employment due to a new manufacturing plant or new public transit line, others have employment stagnation or decline. If employment is going down around your potential investment, it’s time to look elsewhere.
State and local ordinances: Is your area affected by rent control regulations? What kind of squatter’s rights laws are in place near you, and do you feel protected by your state law as a landlord? If you feel that the laws are not conducive to your ability to be profitable as a landlord, maybe it’s time to shop around in another spot.
Property taxes: High property tax has become a nationwide issue. High tax rates could reduce your ability to make high returns, so do your due diligence into local tax policies to make an informed decision on whether purchasing is the right decision for you.
To make money on your next real estate investment, the name of the game is research. The more prepared you are in this journey, the higher you can expect your returns to be. You will be prepared for any common expenses with real estate in your area, and you will know how much you can expect to make from your rental income so you can manage expenses while making a substantial profit.
Related: Want to Invest in a Rental Property? Do These 5 Things First.
