How To Evaluate A Real Estate Investment Property

Americans are increasingly interested in real estate investing and building wealth for their families and futures. But if you’re in this camp, you know that it’s harder than it looks. 

Before you can purchase an investment property, you need to know what to look for. You need an eye for great deals but also well-trained intuition about whether a property will generate enough revenue to offset its costs and yield significant cash flow.

In this article, we cover five tips for evaluating a new property and what to look for in an investment property you’re considering adding to your portfolio. 

Use Comparable Properties 

One of the most important strategies in evaluating a property is to compare local properties in the area that are similar to yours in size, number of bedrooms, and condition. If you want to know how successful your investment will be in a particular market, what better way to know than to find someone who has made the same investment? 

Comparing similar properties is also an important way to manage your expectations and keep them in check. If you have the same type of property in approximately the same condition as Landlord Joe down the street, don’t expect to fill your properties with tenants paying twice the rent as his. 

A formal way to compare similar properties is to conduct a sales comparison. Also known as the price-per-square-foot approach, this method requires you to find comparable properties sold within the past 30 days and calculate their purchase price per square foot. It’s a relatively simple calculation but one of the most useful investment property tips and an easy way to quickly determine how your property stacks up in the local market. 

Consider Location 

Speaking of the local market, location is crucial. The location of your property can turn an unattractive, small place in need of several repairs into a highly desirable apartment within walking distance of hip restaurants, boutiques, and high traffic areas. 

Where is your target market, and what type of people live there? Are those the kind of tenants you’re seeking? If not, you’ll want to carefully reconsider the location you’ve chosen to invest in. The goal should be to find a location your target renters are likely to live or move to due to attractive local amenities like good school systems, proximity to public transit, etc. 

Get a Property Condition Evaluation 

Investopedia defines property value as “the present worth of future benefits arising from the ownership of [a] property.” In addition to establishing substantial monthly cash flow, property owners are most concerned with investing in assets that will grow in value over time or appreciate—for investors who hold properties over the long-term, the current value of a home matters less than its future value. For this reason, understanding how a property’s current condition can influence its future value is an essential real estate evaluation skill. 

One way to estimate your property’s condition is to get a professional property valuation. This report evaluates an asset in its totality, breaking down its individual components’ values and estimating the capital you’ll need to maintain your property over time. Such a report will look at large-scale considerations such as the building’s infrastructure, roofing, and insulation as well as individual systems like the HVAC system, electricity, and plumbing. 

Another way to estimate value is to get a formal appraisal. An appraisal attempts to determine the true value of a property, including factors like location, lot size, demand, and amenities. However, keep in mind that the value of a property may not be fully reflected in its price.  

Calculate Your Expected Net Operating Income and Cap Rate

A property’s net operating income, or NOI, is the overall income your property will generate minus your regular operating expenses. Your net income or NOI divided by the original price you paid for the property is called the cap rate, or capitalization rate. This metric helps you determine approximately how quickly you can make back what you will spend on the property. Cap rate is an estimation of the return of your rental property. A higher cap rate means higher returns, more revenue, and a stronger overall investment. 

Keep in mind that the cap rate calculation can hide a few important factors that could skew the results. When you use cap rate to evaluate profitability before purchasing a property, you’ll need to approximate the rental rate and total expected income, which means the cap rate calculation should come after you research the rents of similar properties in your local area. Additionally, if you buy a low-value home intending to “fix and flip,” the calculation won’t be accurate since it doesn’t include the cost of repairs or renovations or the fact that you’ll be selling the property instead of renting it out.

Lastly, as is always the case with real estate calculations, you should never make a decision based solely on capitalization rates or any one metric. Use an asset’s net operating income /NOI and cap rate in tandem with other evaluation methods. For instance, when determining optimal cap rates for your real estate investments, also consider current market cap rates in nearby locations, the investor’s potential return of investment, appreciation trends in the area, and other factors. You might also want to do a terminal cap rate comparison to compare the property’s current rate of return with the expected rate of return on the day of the property sale.

Perform a Risk Analysis 

Each investment you make in real estate comes with known and unknown risks. You could have trouble filling your units, surprise maintenance problems, zoning challenges, or other difficulties. Understanding and planning for these risks is the best way to mitigate them while you move forward with your investment. 

As you learn how to evaluate an investment, consider how the following factors may or may not change unexpectedly: 

• Property taxes 
• Rising interest rates
• Local industry health and employment rates 
• Cost of essential services, like water and gas 
• Current market value of amenities
• The quality of rental applicants 
• Government policies affecting real estate 
• State and local laws, such as rent control ordinances 
• Evictions 

Before you purchase a property, consider performing a risk analysis to identify the real risks associated with your investment and the potential costs for you. It’s all but guaranteed that something will go wrong at some point with a property acquisition—it’s just a matter of being prepared for those risks when they do happen and doing everything possible to avoid reductions in asset value.

Conclusion 

Many Americans have dreams of starting a successful real estate career in the hopes of achieving financial freedom. But success doesn’t come without hard work, and that means first investing your time in research before investing your money. Use these five strategies as a starting point in your own research and future property deals.