Looking for rental properties can be a very stressful and frustrating thing, especially when investors try to evaluate a rental property. Most investors I know, tend to over-complicate or look for the unicorn that never happens. Most successful RE investors look at rental properties in a very simple way and look for very simple attributes. I have also learned to do that, and I consider that it was the key to finding great deals.
Before you proceed, let me tell you that you can have very different strategies in real estate investing. In my opinion, the most determining factors for choosing the most appropriate methods for evaluating a rental property include:
- The bank lending you money to buy vs buying and renovating a property;
- Aiming at a cash flow vs an appreciation portfolio;
In the following, I will tell you how I evaluate a rental property. I assume I can only borrow money to buy a property (and not renovate). In addition, I assume I am looking for high cash flow deals (and discard appreciation all along).
The main numbers to evaluate a rental property – it’s actually simple math!
I’ve seen lots of investors doing crazy when it came to evaluating a rental property. I actually read someone’s comment on MMM forum which referred to a book called “how to evaluate real estate investments”. This guy spent hours and hours reading a book that supposedly helps to evaluate a rental property. I was shocked… I’ve got 10 units with awesome ROIs and I’ve never spent any money reading books on evaluating real properties…
My general thumb rule is: if you’re spending more than 5 minutes determining whether a rental property is a good deal, you’re doing it wrong. I personally look at two or three numbers and that is it. Below you will find my entire rationale when assessing a deal.
Really important stuff you can’t drop the ball on
In my opinion, the most important things when evaluating a rental property include: 1) knowing exactly all the expenses that the previous owner had with the property, 2) knowing exactly how much money you’ll spend, should you need to renovate it, and add 15% to that just in case and 3) knowing that the current rents are not overvalued.
Where I spent my time when I want to evaluate a rental property
First things first. If I am to buy a property, I first try to find a few properties (say 3-5) that look interesting before going further.
Assuming I already found 5 properties that look like good deals, I move on to the next phase and ask a few questions:
- Is the current owner a motivated seller? (I need to be truthful with you – you won’t know this every time)
- How much money would I have to spend to build this property, and how does it compare to the listing price?
- Assuming there are already some tenants, would they stay if raised the rent by 10%? Do they have any personal relationship with the current owner?
- Assuming there are no tenants, at what price point (in terms of rent) would I need to go to rent the unit in 1 day?
- Because of hidden costs, the renovation of the property will be 50% higher than the quote I’ve got. Is it still a good deal?
OK, now, let us start filtering the properties…
- I only work with very motivated sellers. If the properties are on the market for less than 6 months, I won’t even inquire the real estate agent.
- I only look at properties that would cost me about 5-10 times more to build than the listing price. This is why I look at multi-unit properties. Single unit properties almost never follow this.
- I would try everything to get to talk to the current tenants – you need to check whether this is legal in your country and you definitely need the approval of the current owner and the real estate agent. Do not do try to talk to the tenants without letting them know!
- I would go to a different real estate company, say that I may have that property in the next months and ask for an honest opinion regarding how much the property could rent for!
- I always get two to three quotes on the renovation of the property.
OK, now I am down to 1 or 2 properties. It’s negotiation time…
But wait… what defines a good deal?
This makes me get back to the original question of whether you are aiming at finding a cash flow or an appreciation property. I follow a free cash flow investment model, so I always look at cash flow deals. That is what the following rules pertain to.
It must be paid in up to 7 years
As a cash flow guy, I look forward to getting my capital back as soon as possible, and that is what I think of when investing. How much time will it take for me to get my capital back?
The math is actually quite simple. I (under) estimate the gross monthly income of the property. If 4 or fewer years of similar income pay off the property, I assume it is a good deal. The rest of the time (until 7 years) would pay for property expenses and taxes.
The beauty of this rule is that I use it regardless I borrow money from the bank (in which case I ignore the interest and assume the initial cost and the full price) or not. Of course that, in the case you borrow money, if you buy a property for 100k and 7 * 12 * rental income = 100k, you won’t have it paid in 7 years because you gotta pay interest. However, the rule will still indicate you whether the deal is a good one!
Let us look at my real estate properties and apply the same rationale:
RP#1: Bought all cash, from a very motivated seller. I knew I would never be able to get my investment back in 7 years with this property, but this investment was a slightly different one. Being a 1-unit property, I knew it was very liquid. I bought it so much underprice that my initial idea was to flip it, sell it off and move onto the next property. I ended up renting it out. As tenants are leaving this property next month, I may sell it for a nice profit and acquire another multi-unit.
RP#2: Borrowed money. Paid €41000 (closing costs included) to buy it. Currently, the gross yearly rent income is €6060. It passes the 7-year rule.
RP#3: Borrowed money. Paid €36500 (closing costs included) and spent about €30000 renovating it. Currently, the gross yearly rent income is €5700 but I project it to be €11200 without renovating it further (as I have free units which I will rent out in the next months). It passes well the 7-year rule and in fact is better than 6 years.
I keep things when evaluating rental properties and real estate investments. Of course that you can even take expensive courses that explain how to evaluate a rental property, but in my opinion, the math should stay simple.
I use the 7-year rule, regardless I borrow money to buy the property or not. This rule basically means that a good deal generates the full paid price in 7 years or less. It has worked very well for me since I started to using it and it definitely keeps things simple and efficient. Focus your time on other things that matter, such as finding motivated sellers (who will sell off their properties at huge discounts) and determining whether the current rents are sustainable. Have a few contractors look at the property and tell you whether there is something you missed. Keep the math simple.