Evaluating Rental Properties

Many people have made their fortune by purchasing rental properties. They hold it over a matter of years while they rent it out to tenants. During that time, the property increases in value and can eventually be sold for a handsome profit.

In the best case scenario, a rental property can earn a monthly income while it builds equity. In the worst case scenario, the owner could go belly up trying to cover the monthly shortfall. The difference between the two is often a matter of making realistic expectations about what a property will earn and what it will cost to maintain.

The first step to determining more realistic expectations is to try and determine exactly what the monthly cost will be. You should start by determining the exact amount of your mortgage payment, including insurance and interest and any other fees like private mortgage insurance (PMI). Of course, these numbers will depend on the loan so you should plan on running the numbers for different loans as you shop around for a lender.

You also need to consider other monthly costs. Include any utilities, garbage pickup, etc. that you’ll be responsible for paying. In addition, your calculations should include a safety margin to cover unexpected costs such as repairs and rent during times the property goes unrented. This safety margin might be calculated as a percentage of the rental income. You would generally want this to be around 20% to 30%, or maybe even higher if the property is older and might need additional maintenance. You might also want a higher percent just to be more conservative.

Next, you’ll compare these numbers against what the property will bring in. If the property is already being rented, you can see what the current rent is. Otherwise, a little research will be needed to gain a realistic estimate of what you can charge. Just try and be realistic in your estimate.

Finally, you should run all these numbers against the different loans you’re considering. Here’s where you determine if the deal will produce a monthly income or a monthly liability. If you’re losing money each month, then you should probably move on. On the other hand, if you’re producing a monthly cash flow, then this might just be the one.

There is a fair amount of number crunching involved here. Fortunately, there are tools to guide you through this process and produce simple reports you can use to make your comparisons. I like the free tool at http://www.realestateprofitcalc.com. By taking a more structured approach to evaluating rental properties, you can greatly increase your chances of success.