How to Determine the Profitability of a Real Estate Investment

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How to Determine the Profitability of a Real Estate Investment

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Wondering how to evaluate a real estate investment? Investing can be difficult in any industry, but if you're considering purchasing a rental property, you need to be prepared for unexpected expenses and fees that may arise.

The best way to make money in real estate is to keep your expenses under control through careful preparation to maximize profits. Here are three tips to help you determine if your investment property is profitable.

Related topics: The 6 most important factors that influence the value of investment properties

1. Use comparable properties to determine profitable prices

One of the most important tips for investment properties is pricing them correctly. What is an acceptable purchase price for your potential acquisition and what rental rate do you need to set after the purchase to make a reasonable profit?

The best way to determine a fair price is to use comparable properties. Investors use properties of similar size, condition, amenities, and number of bedrooms in the same neighborhood to determine the profitability of the investment. If you're looking to buy a home that's significantly more expensive than comparable properties in the area, it could be a sign that you have room to negotiate or that you should look for a better deal on another property. Remember that the purchase price is important when thinking about your return on investment (ROI)—in general, the lower your purchase price, the more profit potential you can expect.

You can also use comparables to determine the price of your rental. Potential tenants will most likely do their own market analysis, and if they see that your rental costs a lot more than comparable properties nearby, they probably won't be interested in filling your vacancy. High vacancy rates are a big profitability killer, so price your properties appropriately to reduce vacancy rates as much as possible.

Use a sales comparison or price per square foot approach to research comparable properties. Look for properties that have sold within the last 30 days that are similar to your property, then calculate their asking price per square foot. Once you calculate your own price per square foot, you can see how you compare to the local market.

2. Calculate the expected net operating income and capitalization rate

If you're wondering what to look for in an investment property, two important metrics to consider are the expected net operating income (NOI) and the cap rate, or capitalization rate. These two calculations will help you estimate how profitable your investment is likely to be.

NOI is the total income your property generates minus ongoing operating expenses. Your capitalization rate is your NOI minus the original price you paid for the property. Calculating these numbers will help you determine how quickly you can recoup your expenses on your real estate investment and make a profit. A higher capitalization rate means higher returns, more revenue, and generally a more successful investment.

It's a good idea to calculate these metrics before purchasing your property to determine if the purchase is a good investment decision. However, since you're calculating these numbers before you actually buy, some numbers like rental price and total expected income are only estimates and your results could potentially be skewed.

Related: Smart investors know these 5 rental property secrets

3. Conduct a risk analysis

While any investment involves risk, real estate investing is notoriously volatile due to the unknown risks that come with purchasing a home. Maintenance issues, macroeconomic problems, zoning issues, and other potential money pits will significantly impact the potential profitability of your rental property and the overall success of your investment.

The best way to prepare for these inevitable problems is to plan for them. Before you buy your property, conduct a risk analysis and consider the following factors. Keep in mind that this list is not exhaustive. Continue to do your own research into what problems investors may encounter in your area and prepare for them as well.

  • Employment rates: What is the general employment situation in your area? While some cities are experiencing a boom in employment due to new manufacturing facilities or new public transportation, in other cities employment is stagnant or even declining. If employment is declining in the area around your potential investment, it's time to look elsewhere.

  • State and local ordinances: Is there rent control in your area? What squatting laws exist in your area, and do you feel protected by your state's laws as a landlord? If you feel the laws are not conducive to your profitability as a landlord, it may be time to look elsewhere.

  • Property taxes: High property taxes have become a nationwide problem. High tax rates could reduce your ability to earn high returns, so be sure to research local tax policies carefully to make an informed decision about whether a purchase is the right decision for you.

To make money on your next real estate investment, research is key. The more prepared you are for this venture, the higher your return on investment you can expect. You'll be prepared for all the common expenses of real estate in your area and know how much you're likely to make from your rental income, so you can manage expenses while still making a sizable profit.

Related: Want to invest in a rental property? Do these 5 things first.