Buying an investment property has become a popular way to earn a passive income in the form of rent or earnings by flipping and reselling. However, the best real estate investors know that not all properties are suitable for investment purposes, so it's crucial to know the potential pitfalls and risks. One home could be a cash cow, while another could be a money pit.
But how do you know what to look for in an investment property? Let's break down the top five indicators of a good investment property that’ll have an equally great ROI.
What Makes a Property a Good Investment?
Technically, any property that allows you to earn more money is a good investment. However, if one property can net you $10,000 and another can net you $25,000, the latter is an obvious better option.
To determine how valuable a property is before investing in it, there are a couple of metrics you need to calculate. Those metrics are the one-percent rule and the cap rate. We break down both below.
The One Percent Rule
This rule dictates that the monthly rent for a property should be about one percent of the purchase price. For example, if you buy a house for $150,000, the monthly rent should be $1,500. However, you should also pay attention to long-term rental rates for similar properties in the area to see if that number is below or above the average.
The Cap Rate
This rate is a bit complicated to calculate, but it can help you compare different properties to see which one is a better investment. It works like this: first, multiply the rent by 11.5 (a whole year minus a two-week vacancy period). Subtract that number from your monthly expenses (maintenance, utilities, etc.). Then, divide that number by the purchase cost and multiply it by 100 to get your cap rate.
Here’s an example: Let's say there's a property you can buy for $150,000. The monthly rent would be $1,500, giving you an annual gross income of $17,250. Let's say your monthly bills are $800 (don't include a mortgage), giving you a yearly total of $9,600. So, your net income would be $7,650. Divide that by the purchase price (7,650/150,000) and multiply by 100. In this case, the cap rate is 5.1 percent.
Overall, the higher the cap rate, the more money you can earn from a property. So, the goal is to find a place that allows you to have a high rental rate but a low property cost.
What to Look for in an Investment Property
Because there are so many variables to pay attention to when investing in real estate, you need to know which elements have the most impact on your potential earnings. Here are five factors to look for in an investment property.
1. Good Location
As the saying goes, the most important thing when buying property is "location, location, location." However, there are a few other factors to consider when comparing different locations, such as:
- Growth and Demand—Ideally, you'll want to buy property in a city that's up-and-coming and not on the decline. Look for places with a growing job market and population, which indicates the demand for housing will also increase.
- Natural Disasters—Virtually every area of the US has to worry about natural disasters. Wildfires, earthquakes, hurricanes, and tornadoes can all damage or destroy your property, and many of these incidents are not covered by home insurance. So, you have to consider the added costs of supplemental insurance and how it impacts your profit margin.
- Desirable Neighborhoods—Just because a city is growing doesn't mean that every part is as desirable as the next. Pay attention to the livability index of each neighborhood you’re considering. The higher the rating, the more likely you can find long-term tenants or flip the property for a higher amount.
In addition to considering whether the home has a good location, the home’s proximity to you is also a factor you should take into account. Is the home two streets over? If so, you’ll have the option to maintain it yourself. Or, is the home two states over? In this case, you may need to consider hiring a property management company.
2. Low Maintenance Features
At first, it may seem like a good idea to buy a cheaper fixer-upper of a property. However, when you account for the necessary renovations and repairs, you might not make as much of a profit. In some cases, older homes can be too expensive to be profitable, or your margin will be so thin that it's not worth buying.
Instead, it's much better to invest in a newer model that doesn't need as much maintenance and upkeep. Newer appliances, newer plumbing, and newer electrical systems offer peace of mind and are less likely to create headaches later on. Also, you need to make sure it has high-quality furnishings and installations that won't break down quickly.
Finally, if a property comes with big yards, you may have to consider landscaping and monthly lawn maintenance. While tenants can handle mowing, you can incorporate landscaping into the rent and make it more desirable for potential tenants.
3. Low Property Taxes
One of the downsides of buying property in a high-demand area is that the annual property taxes can be higher. That said, it's best to try and buy property close to high-demand areas so you can pay lower taxes every year. For example, a 1.5 percent tax on a $300,000 house costs $4,500 per year, or $375 per month. However, if you could get a similar property with a 0.75 percent tax, that would only be $2,250 per year or $187.5 per month.
Also, it’s important to consider that property taxes may go up year after year, so if you start with something low, you have more flexibility. However, if it's already high, you'll have to raise rent to compensate for increases.
4. Easy Upgradeability
Even if you end up choosing a fixer upper, it’s important to find a property that is easy to upgrade and renovate. For example, choosing a property with a solid structure can make the renovation process smoother and more cost-effective. Additionally, considering a property with a layout that aligns with your planned renovations can minimize the need for major structural changes and reduce overall remodeling expenses. However, even a home that is easy to upgrade will take time to renovate.
By comparison, new construction homes offer turnkey solutions. Many of them are move-in ready, so you can start earning rent money immediately. Plus, you don't have to pay extra to renovate or upgrade any of the internal systems like plumbing, so while you may pay a little more upfront, you could wind up making more money overall.
5. Homeowners and Natural Disaster Insurance Costs
When considering what to look for in an investment property, you can't forget about homeowners’ insurance. Because you'll be renting the property to tenants, you need more coverage than you would as a primary resident.
Additionally, most home insurance policies don't cover natural disasters like hurricanes and earthquakes. Or, if they do, you have to pay a premium on top of your monthly payment. Some regions are much more disaster-prone than others, so you need to pay attention to insurance rates.
For example, Florida has the highest insurance rates in the country because of the number of hurricanes it experiences. Also, other states in the Gulf Coast region can have higher rates, particularly when they're close to the water. Generally, basic policies don’t cover flooding (even from a hurricane), so you have to buy separate flood insurance.
Make sure to keep these costs in mind when calculating your net income and cap rate. While you can offset these costs slightly via rent increases, you don't want to raise rent so much that it scares off long-term tenants.
6. Type of Property
Lastly, you should consider the type of property before investing. Different real estate properties, such as multi-unit buildings, single-family homes, and condominiums, can affect everything from rental income and expenses to renters and maintenance.
If you opt for a single-family home, you may be able to earn more rental income than with a condominium. However, exterior maintenance duties may fall on your shoulders, while an HOA would most likely maintain the outside of a condo. But, an HOA generally requires monthly or annual dues that you may not be willing to pay. With that said, it’s best to make a pros and cons list of each type of property, weighing their benefits and challenges equally.
How to Find Investment Properties
There are a few ways to find investment properties that can give you a decent return. Those options include:
- Real Estate Agent—This is probably the best option since your agent can handle the detailed work and potentially find properties that aren't listed on public sites.
- Multiple Listing Site (MLS)—You can conduct your own searches on sites like Zillow or Redfin, but you have to be able to devote time and energy to researching properties and comparing cap rates.
Additionally, you need to know your own details, such as how much you can afford, what kind of renovations you can handle on your own, and how quickly you want to find a place. Overall, the more pre-planning you can do, the better off you'll be.
The Final Word on Finding the Right Investment Property
As you can see, there are many factors to consider when figuring out what to look for in an investment property. A worst-case scenario is that you invest in a money pit, meaning you wind up losing money in the end. To ensure you end up with a cash cow, look for a home in a good location with low maintenance, low property taxes, and if possible, in good condition. Even if something seems like a good deal at first, do your due diligence in studying the property and determining its profitability. You’ll be a real estate professional in no time.
New construction homes are often the best choice for an investment property because they can be move-in ready, require less maintenance, and are built to modern building codes. If you’re interested in buying a brand-new home, check out our selection of available properties today!