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6 Tests Every New Rental Property Should Pass (Before You Make an Offer)

On the surface, real estate investing is relatively simple.

Find an affordable property, rent it out, and collect the proceeds passively, taking care of any issues if and when they arise.

Unfortunately, as any seasoned real estate investor can tell you, worthwhile investment properties aren’t always easy to spot. On top of that, the heuristics we used to determine which properties are worth investing in aren’t always perfectly reliable.

There are several tests that you can use to gauge whether an investment property is worth genuinely considering, and you should run all of these tests for each property you consider – long before you ever make an offer.

So what are these tests? What are their limitations? And how should you use them in pursuit of your real estate investing goals?

Testing and Rules of Thumb in Real Estate Investing

First, let’s briefly discuss how to use our tests and other “rules of thumb” in real estate investing. Like any rule of thumb, these rules are meant to provide loose guidance without necessarily tying you down or giving you firm, reliable answers.

A property that doesn’t pass every test may still be extremely valuable as part of your real estate portfolio, and likewise, a property that passes every test may still be a poor investment choice.

If you want to use tests and rules of thumb effectively, you need to be able to discern the advantages and disadvantages of this approach.

Let’s start by looking at the advantages:

  •       Simplicity. As you’ll see, most of these tests can be learned and fully utilized after just a few minutes of education and experience. With the tests we’re about to outline, you can immediately turn to any local market and start evaluating listed properties for their potential as investments. You don’t need any complicated formulas or spreadsheets, nor do you need a wealth of real estate investment experience to get started. This is one reason why tests are so popular; they’re extremely accessible and easy to understand.
  •       Objectivity. Buying a property is a complex decision in which you’ll have to weigh both objective and subjective factors. But as human beings, we tend to be emotional, borderline irrational creatures that suffer from cognitive biases and skewed perceptions. Part of the value of these tests is that they are, by definition, objective. Most of them involve calculating a number or objectively determining a basis of comparison. This can help you filter out your emotions and cognitive biases, so you can make decisions more logically and analytically.
  •       A basis for comparison. As you’ll see, many of these tests offer a pass/fail dynamic; the property either passes the test, indicating it’s worth considering, or it fails the test, indicating that it’s probably best passed on. But these tests are also highly useful as a basis for comparison. For example, if you have three different properties you’re considering, and they all pass the same number of tests, you can determine which properties passed with the highest scores to determine which properties, among these, would be the best additions to your portfolio.
  •       A check against your gut. Finally, objective tests and rules of thumb are useful to experienced real estate investors who may simply be interested in validating conclusions they’ve already drawn. Once you’ve managed a few properties on your own and you have some more experience buying and selling, you’ll develop an investor’s intuition for the properties that are best suited to your needs. Still, it’s a good idea to crunch the numbers and determine whether your hunches are accurate or whether it was just good marketing on the part of the real estate agent. 

These are the drawbacks:

  •       Geographic blindness. Most of these tests are designed to be universal, which is an advantage in and of itself. However, these tests can’t tell you much about the local dynamics of a given market. If an area is particularly popular and in demand, property prices may be inflated, making the properties themselves seem less favorable; however, the area may be so absurdly popular and worth investing in that it’s worth taking a small loss on net income for the promise of future returns. Much depends on the city and neighborhood in which you’re investing.
  •       Variable limitations. In line with this, the simplicity and accessibility of these tests introduces the drawback of variable limitations. As you probably know, there are hundreds of little variables that you should consider as part of your real estate investing decisions; no simple equation can incorporate all of them. You may be able to ballpark the cash flow of a given property by crunching the numbers accessible to you, but you’ll need to dig much deeper if you want a full understanding of the dynamics of a given property.
  •       Market agnosticism. These tests are also designed to be market agnostic, meaning they don’t take the state of the real estate market into consideration. For the most part, you won’t be looking at mortgage interest rates, real estate inventory levels, or market dynamics (like whether it’s a buyer’s market or seller’s market) when you conduct these tests. Timing the real estate market aggressively isn’t a good idea for most investors, but you should still take the state of the market into consideration when making your decisions.

In short, these tests are very useful, but they have limitations, so use them as only a portion of your due diligence responsibilities.

Tests Every New Rental Property Should Pass

With that out of the way, here are some of the most important tests that every new rental property should pass:

  1.   The 1 percent rule (or 2 percent rule). The 1 percent rule is a rule of thumb guiding investors to invest only in properties capable of making at least 1 percent of their purchase price in gross monthly revenue. Some real estate investors even prefer the 2 percent test, a variation which demands higher gross rental income generation. For example, if you purchase an investment property for $200,000, you should make sure it can generate at least $2,000 of consistent gross monthly rental income. If you’re following the stricter rule, it should generate $4,000 of consistent gross monthly rental income. There are certainly properties that fail this test that are valuable additions to your portfolio, but passing the 1 percent rule is a great starting point for analyzing most properties.
  2.   The demand test. You also need to be able to objectively determine whether this property is going to be capable of remaining occupied consistently. Vacancies have the power to kill any real estate investment strategy; if there’s no one in your properties, you’re not going to generate money, but you’ll still have operating expenses, killing your cash flow and your profitability in the process. There are many ways to test for demand. Some properties have historical rental records that can tell you how long and how consistently they have been occupied, and in fact, some properties may have consistent tenants when you buy them. Failing this, take a look at similar properties in the area to determine how many tenant applicants there are and how consistently the properties are occupied.
  3.   The square footage test. The average rent per square foot for U.S. apartments ranges from around $0.74 to $2.95 per month per square foot, depending on where you live (though take note: these data are from 2018, the most recent year on record for this metric). You can calculate the approximate rent the property will generate based on historical data or comparable properties in the area. Consider lowering the amount slightly to estimate conservatively and account for any errors or biases. Take the monthly rent figure and divide by the available square footage of the available units to determine whether you’re in reasonable territory. For example, in the state of Arkansas, the average rent per square foot per month is $0.75. If you have a 2,000 square foot property, it should generate, on average, $1,500 in rent. If the property can generate more rent than this, you can consider it an above average property for the area. A below average property isn’t necessarily an automatic discard, but you can consider it a failure of this specific test.
  4.   The net operating income (NOI) test. Net operating income (NOI) is a measure of income as it relates to operating expenses. All you have to do is ballpark the income generated by the property (which you should have done already), subtract the operating expenses, and determine whether the final result is positive or negative. This test is perhaps best done annually, as it will account for operating expenses that won’t apply on a monthly basis; for example, you may pay for insurance premiums or property taxes annually. Try to incorporate as many operating expenses as are conceivable, including maintenance, repairs, taxes, insurance, management expenses, and so on. Obviously, real estate investors are interested in the most profitable possible properties. However, any property that can reliably break even has a chance to be a valuable addition to your portfolio; in rare cases, even a property with a mild negative return at the beginning may be worth investing in, on the basis that it will increase in both value and rental income potential over time. Accordingly, take this test with a massive grain of salt and consider using it as a basis for comparison, rather than a simple pass/fail test.
  5.   The cap rate test. You can calculate the cap rate of a given property by dividing the NOI of a property by the purchase price. You already have the NOI if you’ve been following this guide, so it should be a pretty simple calculation. The cap rate is an excellent basis of comparison, which you can use to compare different properties against each other.
  6.   The future growth test. Finally, examine the property for potential future growth. This is by far the most subjective and potentially complicated test on this list, since so many variables can impact how a property grows in value with time. Examine historical growth rates for the neighborhood as well as any meaningful metrics that can help you determine how the neighborhood is growing. Are employment opportunities rising or falling? Are schools in the area getting better or worse? Are there elements of cultural appeal, such as a thriving art scene or infrastructure overhauls that would draw more people in? Are the city and the state where the property is located growing in terms of population? No one can predict the future, but you can make a reasonable guess based on these objective metrics and others.

Other Factors That Can’t Be Easily Tested

We would be remiss if we didn’t include some other factors worth including in your analysis that can’t be easily tested or reduced to a rule of thumb.

  •       Neighborhood quality/general location. Always think about the neighborhood quality and general location of the property, as subjective dynamics can play a massive role in long-term property value as well as income generation potential. For example, neighborhoods with low crime rates, beautiful aesthetics, and reliable access to transportation perform reliably better than counterparts without these perks.
  •       Property condition and upkeep requirements. Operating expenses are always a ballpark, but you can generally count on much higher operating expenses with older and more poorly maintained properties. Unfortunately, even with a home inspection, you can’t always know what types of issues a property will face in the future. However, some properties are worth a higher purchase price than usual if they offer a better initial condition and minimal upkeep requirements in the future.
  •       The market. As we’ve briefly mentioned, you need to consider the state of the market. A buyer’s market is favorable to buyers, while a seller’s market is favorable to sellers. Additionally, certain conditions, such as relatively low mortgage rates or relatively high inventory levels, could help you buy a property more easily or more cheaply. These types of effects are so powerful that it sometimes makes sense to override other objective tests due to your findings here.
  •       Unique advantages. Some properties may have unique advantages that can’t be easily calculated or even objectively determined. For example, properties with available parking spaces in an area that’s hard to park in usually may be capable of demanding more than market rent.
  •       Personal interest. It’s a subjective factor, but a reasonable one to include in your analysis: gauge your personal interest in the property. Is this a place you could live in in the future? Could it function as your primary residence until you fix it up and turn it into a rental property? Is it in a neighborhood you strongly believe in, even in spite of some of the objective metrics? Obviously, you’ll need to temper your emotions and impulses in a decision like this, but your personal interest shouldn’t be totally disregarded.
  •       Personal portfolio balance. Consider the state of your portfolio as well. A property that fails a couple of tests may still be worth considering if it provides a risk hedge in your portfolio or allows you to further diversify. For example, you may be interested in investing in properties in many different areas, or if you have a portfolio full of single-family properties, you may be interested in branching out to multifamily properties.
  •       Personal risk tolerance. Personal risk tolerance is unique to you. Depending on the size and scope of your portfolio, as well as your personal interests, you may be more or less willing to take on properties based on their objective characteristics. For example, if you’re a relatively aggressive investor and you’re more interested in building your portfolio than finding perfect opportunities, it may make sense to add a property to your portfolio even when you aren’t confident in its ability to make above-average profit for the area.

We get that investing in real estate is complicated.

That’s why we try to simplify things.

Sure, you can run all these tests and calculations on your own – and manage your own portfolio. But sometimes, it’s better to lean on real estate investing experts for a bit of guidance and help.

If you’re in the market for a new property, if you’re selling a property, or if you just need help managing your existing real estate portfolio, you can benefit from working with us. So reach out today – and find out just how much we can do for you!

Derek Bryan
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