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.
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.
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.
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.
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:
If math isn’t your strong suit, then ask your accountant or financial planner to calculate these and other numbers for that potential investment.
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.