Andrew Carnegie said, ” Ninety percent of all millionaires become so through owning real estate.” Although rental investments can be profitable, they can also be risky. If you’re an investment newbie, you should learn the common pitfalls in rental property analysis and how to avoid them.
Rental property analysis is a complex process. Common pitfalls include not understanding the rental income potential, operating expenses, or market conditions and overlooking financing costs, property needs, and the importance of sourcing accurate data.
Conducting a rental property analysis before buying is one of the most accurate predictors of investment success. Understanding the common mistakes and how to sidestep them will help you minimize the risks of buying rental properties.
What is a Rental Property Analysis?
If you’re new to rental property investment, you may first need a quick definition of a rental property analysis. This analysis is the homework you do before purchasing a specific rental property. This research involves:
- Researching local rental rates
- Analyzing the operational expenses
- Assessing the area’s typical vacancy rates
- Analyzing the local economic conditions
- Identifying your target tenant demographics
- Considering the market trends in the area
- Evaluate the potential investment against comparable properties (rental comps)
- Researching the return on investment
- Drawing reports from platforms that collect the above data for the area
How Can You Avoid the Pitfalls of a Rental Property Analysis?
A rental property analysis is only helpful if you do your homework properly to ensure accurate information. Here are some of the common errors investors make when conducting one.
Underestimating the Operating Expenses
Many investors focus on mortgage payments and property taxes but forget to include additional operating expenses.
To avoid this typical error, plan for all possible expenses, including maintenance, utilities, insurance, property management fees, taxes, and vacancy losses. The 50% real estate rule states that investors should allocate approximately half of the property’s gross income to operating expenses.
When you own a property, you will always have unexpected expenses, so factoring these costs into your rental property analysis is a must. When budgeting for maintenance costs, you can allocate $1 for every square foot of the property or set aside 1% of its value. A well-maintained property attracts and keeps better tenants.
Overestimating the Rental Income Potential
One of the biggest mistakes new investors make is assuming that their property will generate high rental income. This often leads to cash flow problems when the property is vacant or if tenants can’t afford the expected rent.
To avoid this pitfall, research local rental rates thoroughly. Look at similar properties (rent comps) in the area, and don’t rely on inflated figures from real estate listings. The TPN Vacancy Survey for the first quarter of 2024 indicates that national vacancy rates are down from 6.69% to 4.42%. This can change for many reasons, so factoring these figures into your analysis is imperative.
Start with realistic rent expectations. Keeping rentals occupied with a reasonable rent is better than long vacancies with high demands.
Ignoring Market Trends
Not researching the local market trends could land you with a failing investment property. You can sidestep this error by studying the local market trends before buying. Keep your eye on the property values in the area, analyze the supply and demand, see how long properties stay on the market, and note the inventory levels.
You should also research local economic conditions, like population trends, job growth, and planned infrastructure developments. The best sources of information are local real estate and property management professionals. Investing in areas with strong rental demand and job growth will help keep your rental in high demand.
Overlooking Finance Costs
Many investors focus too heavily on the property’s purchase price and overlook the financing or closing costs. These may include:
- Mortgage payments
- Interest
- Principal
- Title search
- Loan origination fees
- Transfer tax
These financing fees can quickly add up and affect your overall cash flow. Always account for your closing costs when analyzing a property’s profitability. Consider the total cost of the mortgage to assess whether your investment will stay profitable over time.
Ignoring Property Management Needs
Many new investors have no idea of the time and effort necessary to manage a rental property. Whether it’s finding tenants, handling repairs, or enforcing lease terms, efficient property management is non-negotiable if you want your property to remain profitable.
Whether you’re a novice or a seasoned investor, employing a reputable property manager is the best way to prevent your property from falling into disrepair or dealing with tenant issues.
Factor in about 8-10% of your rental income for professional management. It will take a heavy burden off your back and prevent high tenant turnover.
Overlooking Data from Rent Comps
It’s a huge mistake to overlook data regarding comparable properties in the neighborhood. This information can provide clues on how your potential investment compares to the local rental market.
When gathering data on rent comps, consider the following factors:
- Comparable properties should be within three blocks of your potential investment.
- They should have a similar square footage.
- Rent prices should be similar to what you expect to charge.
- Comps should have the same number of bedrooms and bathrooms
- The lot sizes should be similar.
- They should be in a similar condition to your potential investment.
Neglecting Key Calculations
Maths might not be your strong point, but neglecting profitability calculations would be a fatal faux pas. Number crunching is crucial before purchasing a property. Having a clear picture of the rate of return will indicate the potential investment’s profitability. Depending on the market conditions, location, and property management, investors should expect an 8-12% return on their investments.
Essential metrics for rental property analysis include: (Linking opportunity: The Key Metrics Investors Should Consider in Rental Property Analysis)
- Cash flow – the net amount after expenses are paid indicates whether or not you have a positive cash flow.
- Capital appreciation – how much a property’s value increases over the long term.
- Cap Rate: This rate determines the annual ROI by dividing the NOI (net operating income) by the current value of the property.
- Cash-on-cash return – calculates the yearly return on the amount of cash you would invest.
Ultimately, purchasing a rental property is an investment that should provide a decent ROI, so a finance-savvy professional must run the numbers before you invest.
Ignoring Real Estate Tools to Access Accurate Data
Conducting a rental property analysis manually would not only be tedious but also fraught with potential pitfalls through human error. To avoid making these mistakes, use tools and platforms like Zillow and Redfin that produce accurate reports for properties in the area you are considering investing.
Using reputable sources, such as the U.S Census Bureau, city planning departments, or county assessor offices, will give you all the information you require on rent comps and the local market trends. Balancing the data against what local professionals have to say should provide a fair interpretation of the investment’s likely profitability.
Conclusion
Investing in rental property is a great way to build wealth but requires careful analysis. Research is key as you consider the income, expenses, local market conditions, and comparable properties to avoid the common pitfalls in rental property analysis. Analyze now, and you won’t be sorry later.