Let’s say you’ve come across a potential investment, one that involves the purchase of a rental property. And let’s also say that the individual making you aware of this investment tells you it’s a sure thing, offering great returns with little risk. After all, it’s real estate, right? And real estate is supposed to be a solid investment.
Before you write a check or transfer funds to get a piece of that action, stop and think. First of all, there is no such thing as a sure thing when it comes to investments—they all carry risk. And second, there are ways in which you can—and should—evaluate that rental property to ensure that it meets your expectations and plans.
The following is a due diligence framework to help you analyze that rental property.
The Property
Consider the property age and shape. Bring in your qualified inspector to examine the plumbing, circuitry, and any potential pest infestations. Then make a realistic assessment about how much more will need to be invested. For example, you could buy a fixer-upper for far less than you might pay for a newer property. But that fixer-upper will likely require additional funds for repairs and improvements.
The Location
Knowing the neighborhood in which that property is situated is important, as it determines the types of tenants interested in renting. College student tenants will have different needs and requirements than families or 50-plus. Other location considerations include property taxes and crime; be sure both of these are low.
Supply and Demand
It’s important to check out the competition near your target property. This includes the actual number of similar rentals. Also perform due diligence on listings and vacancies in the neighborhood. High vacancies and listings could suggest seasonal rental cycles or even a declining neighborhood. It also means you might have to charge a lower rent to attract tenants.
The Numbers
Determining whether a rental property is a good investment means running numbers to ensure that your return on investment makes moving forward worthwhile. There are many calculations and formulas to perform. Here are a few:
- Cash flow (monthly or annual profit/loss)
- Net Operating Income (property income, excluding acquisition costs)
- Return on Investment (annual return divided by investment costs)
- Capitalization rate (property returns, independent of financing)
If math isn’t your strong suit, then ask your accountant or financial planner to calculate these and other numbers for that potential investment.
Your Ownership Tolerance
Finally, it’s a good idea to determine if you’re cut out for life as a landlord. Even if you hire a property management individual or firm to help deal with tenant issues and repairs, you’ll still need to be involved with operations. You’ll also need to understand laws and regulations, and know how to market your property. Basically, investment property ownership comes with a list of responsibilities requiring financial, physical, and even emotional resources.
If you’re still interested in real estate ownership, but don’t want to deal with the hands-on commitments, other investment options to consider are real estate investment trusts (REITs) or Delaware Statutory Trusts (DSTs). These are examples of passive ownership, in which other entities take on the acquisition, management, and disposition of real estate. You end up with potential cash flow and returns, without the hands-on activities.
Whether your investment plans call for direct or passive ownership, be sure to perform all necessary due diligence with help from your financial planner and/or accountant.
All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure. The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. A REIT is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages. REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate. There are risks associated with these types of investments and include but are not limited to the following: Typically no secondary market exists for the security listed above. Potential difficulty discerning between routine interest payments and principal repayment. Redemption price of a REIT may be worth more or less than the original price paid. Value of the shares in the trust will fluctuate with the portfolio of underlying real estate. There is no guarantee you will receive any income. Involves risks such as refinancing in the real estate industry, interest rates, availability of mortgage funds, operating expenses, cost of insurance, lease terminations, potential economic and regulatory changes. This is neither an offer to sell nor a solicitation or an offer to buy the securities described herein. The offering is made only by the Prospectus.
