4 Things to Know When Looking for an Investment Property

By Holly Johnson

Hero_Images

Shopping for an investment property is a major undertaking. Here, four guiding principles to consider while assessing the ROI of a potential buy.

At the start of an investment property search, most buyers have one question: what will my return on investment be? While this is a great business question, potential buyers often overlook the more granular details like repairs or rental rates in the area first. Calculating ROI isn't an exact science—especially in the real estate market—so it pays to do some research to ensure a sound investment.

In order to answer the big question of ROI, investors should cover these details on every property hunt:

1. Understand the Cap Rate:

Cap rate (or capitalization rate) refers to the net ratio of operating income to property value. In other words, the percentage of income coming in compared to the property's actual value.

“If you can't charge enough rent to make profit, why are you doing it?" says landlord Dana Kelley, who has owned a three-family building in Lowell, Massachusetts, since 2007. "I knew I wanted two thirds of the rent to pay for everything and one third of the rent to be the profit. That way, if one apartment was empty or a tenant wasn't paying their rent, I wouldn't be losing money to pay the bills."

Planning for vacancies is crucial, and failing to consider these costs before purchasing a property is a common pitfall for new landlords. “People often assume their properties will never be vacant," says Samantha DeBianchi, founder and CEO of DeBianchi Real Estate, a company that works with buyers shopping for rental properties.

To gauge the vacancy issue (and to understand the cap rate better) Debianchi advises doing a little homework: inquire with the seller about the building's current tenants (Are they planning to move out? Is there potential to raise rent?) and canvass the area to see if nearby rentals are staying occupied at a fair price.

2. Don't Forget About the Repairs:

If the unit is turn-key, immediate repair costs can be close to nothing, but if the building is older or not originally constructed for multiple families, the initial investment could be much greater.

Kelley, for example, says his property was a maintenance disaster when he looked at it. Still, the location was ideal, so he bought it and poured some money into the home up front. The strategic investment paid off over time and eventually became a selling point. “I had to re-plumb the whole building and install a highly efficient heating system on each floor," Kelley says. "Now, every time I show an apartment, I tell the same story [to the potential tenant]: here's what I did to save you money."

Never believe a real estate agent who says upgrades will earn a certain percentage on top of an investment, adds DeBianchi. Agents are known for inflating numbers to make a property seem more appealing for buyers. Instead, buyers should do their own math to assess the cost of both immediate repairs and long-term maintenance, like a new roof or an HVAC unit upgrade.

3. Analyze the Area's Potential for Rentals:

Potential buyers should do their best to understand how well a property might appreciate over time due to rental increases, the pace of inflation, or local improvements. DeBianchi suggests attending local meetings to learn about potential commercial projects and community issues. These meetings are also a great way to gauge community passion: if residents are heavily involved in planning, that's usually a good sign.

Also consider what's being built, says DeBianchi. If residential projects, commercial projects, restaurants and transportation projects are on their way to an area, this may justify higher rents in the future.

“You have to be wary and keep your ear to the ground," adds Kelley of canvassing an area.

4. Accept the Initial Risk and Reap the Potential Reward:

Any investment comes with a level of risk, and rental properties are no different. With more information about a building's occupancy, the repairs necessary (both immediate and eventual), and the potential appreciation, buyers can better estimate ROI.

“Figure out what is important to you, what your goals are, and work from there," says DeBianchi—whether that's passive income, long-term growth or both.

Remember that spotting the perfect investment takes time. “I thought about this for a long time," says Kelley on his investment process. "I must have looked at 50 properties and only one or two buildings fit all my requirements."

To find a property that will turn a profit, lots of research and a desire to learn are the keys to overall success.

Author_Holly_Johnson
About the Author:
Holly Johnson
Holly Johnson is a financial expert and award-winning writer who is obsessed with frugality, budgeting, and travel. In addition to serving as contributing editor for The Simple Dollar, Holly writes for well-known publications such as U.S. News and World Report Travel, Personal Capital, Lending Tree and Frugal Travel Guy.