5 Simple Ways to Evaluate a Rental Property and Win

Real estate is one of the hottest topics in the investing world, and for good reason. Everyone dreams of that steady passive income, right? Especially for high-income professionals like physicians, real estate seems like the key to unlocking an additional stream of cash flow. But amidst the promises of easy money, many don’t realize this: buying a rental property isn’t simple—unless you know exactly what metrics to look for.

We’re going to break it down into bite-sized pieces. Here are five simple ways to evaluate a rental property and put yourself in the best position to win.

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Let’s start by walking through two key evaluation metrics: the 55% Rule and Cap Rates. Then we’ll dive into the top three factors that will help you increase your odds of success.

Understanding the Basics of Rental Property Evaluation

Popularity of Real Estate & Passive Income

There’s no doubt that real estate stories tend to captivate people—whether it’s a gut-wrenching loss or an overwhelming success. But more than the stories, it’s the idea of passive income that catches everyone’s attention. However, here’s the truth bomb: passive income isn’t passive.

Real estate investments require a lot of work upfront, and they also demand ongoing vigilance. Despite the illusion that income will continuously flow in without effort, you’ll be managing expenses, keeping up with tenants, and handling repairs. That said when you evaluate properties the right way, you give yourself a much higher chance of actually getting a positive cash flow.

Goals of Evaluating Rental Properties

So, what exactly should you be looking for? You want to focus on key numbers and strategies that help you stay profitable. I find that focusing on these five areas—evaluation metrics and strategies—can simplify what can seem overwhelming at first.

Let’s dive in.

The 55% Rule

What is the 55% Rule?

The 55% Rule is your first line of defense against making a bad decision on a rental property. At the core of this rule is something called Net Operating Income or NOI.

NOI = Rent – Operating Expenses (Excludes the mortgage).

This rule says that your operating expenses should account for only about 45% of your rental income. That leaves the remaining 55% of your income to cover your mortgage—excluding any extras. The key point here is that this calculation helps you know if you’ll be cash flow positive.

What’s Included in the 45% Expenses?

When I say operating expenses, I’m talking about:

• Insurance: It’s probably the most basic expense you can’t avoid.
• Maintenance: You’ll need to continuously keep the property in good shape.
• Property Taxes: This one’s huge and non-negotiable.
• Repairs: Trust me, repairs will happen. Tenants will call you at 3 A.M.
• Vacancies: Prepare for the fact that you won’t always have tenants. Learn to plan for vacant months.
• Snow & Lawn Care: Even during vacancy, someone’s got to shovel the snow or mow the lawn.
• Management Fees: Even if you think you’ll manage things yourself, don’t forget—your time is valuable.

If you’re watching every dollar, you’ll probably be tempted to cut costs by avoiding a property manager. But here’s the secret: even if you manage the property yourself, your time has a cost. Especially for high-income professionals like physicians—your time is one of your most valuable resources. So, don’t skip factoring in that management cost!

Example of the 55% Rule in Action

Let’s say you’ve got a rental property that brings in $2,000 a month in rent. Applying the 55% rule:

$2,000 x 0.55 = $1,100

So, you’re left with $1,100 to cover your mortgage—principal and interest. If you follow the rule, after paying all your operating expenses, you should be left with enough to cover the mortgage and still stay cash flow positive. If the numbers don’t add up, it’s a good indication you need to walk away.

Cap Rates

What Are Cap Rates?

The second number you need to know when evaluating any rental property is the Capitalization Rate or Cap Rate. The cap rate allows you to compare properties by factoring in both their income and their value.

The formula is simple:

Cap Rate = NOI / Property Value

Cap rates are super useful for comparing multiple properties. Let’s say you’ve got your eye on a few different homes, but they’re all at different price points. The cap rate lets you compare their profitability in a straightforward way.

How to Calculate Cap Rates

Let’s get into the math.

If you’ve got a property with a value of $200,000 that generates an NOI of $12,000 annually, here’s how you calculate the cap rate:

$12,000 / $200,000 = 0.06 (or 6%)

That’s a 6% cap rate. Simple, right? Understanding the cap rate lets you look beyond surface-level numbers and dig into the actual profit potential.

Cap rates work best as a comparison tool. For instance, if one property offers a 4% cap rate and another offers a 7% cap rate, the higher cap rate suggests it’s a more profitable deal—assuming all other factors are equal.

3 Key Strategies to WIN at the Rental Game

Importance of Price

Now that you’ve mastered evaluation with the 55% Rule and Cap Rates, let’s discuss winning strategies.

First up is price. While location has always been the top concern with primary residences, I’d argue price deserves top priority when investing in rental properties. High home prices also mean smaller margins, and you’ll feel the pressure when it’s time to cover the mortgage.

Timing Matters

As of mid-2024, we’ve been in a high-demand real estate market for a few years. Prices are still elevated, and we could see a market pullback. If that happens and you overpay for a property, you could be in serious trouble. You’ll be left in a tough spot needing to sell a property that’s lost value. Don’t let that happen.

How Do You Get a Good Price?

Build rapport with a real estate agent. Someone who knows the market inside and out will get you access to off-market deals or properties that haven’t been snapped up yet. It’s competitive out there, and if it’s your first rodeo, don’t expect them to send you the hidden gems.

Also, don’t be afraid to walk away. If a price doesn’t make sense for your long-term profitability, walk away.

Down Payments in Rental Property Purchasing

Why It’s Not Like Your Primary Home

Most of us are familiar with the concept of putting down 20% on our homes. But when it comes to rental properties, banks see things differently. For investment properties, you’ll likely need a larger down payment—somewhere around 25%-30%—to stay cash flow positive. More down can help buffer against rising interest rates and ensure you’ve got better margins.

Here’s where it gets tricky: as interest rates go up, so does the amount you need to put down. If you’re working with 6%, 7%, or even 8% interest on a rental property, you may need to put down closer to 30% or more to keep the numbers in your favor.

Pay More Now, Save More Later

When you’re cash flow positive, everything feels easier. The more you can put down upfront, the lower your monthly mortgage payments will be—making it easier to stay profitable over time. This also gives you more flexibility if the market experiences a downturn. Your down payment becomes your safety net, allowing you to sell without taking a huge hit.

A Few Ways to Increase Your Down Payment

• Throw in more cash upfront.
• Negotiate a lower price.
• Use Sweat Equity: Take on DIY work like painting or fixing up the property yourself to increase its value.

Sweat equity not only helps the property’s value but improves your mortgage-to-loan ratio. Win-win!

Minimizing Transaction Costs

What Are Transaction Costs?

This seems obvious, but transaction fees can sneak up and eat away at your profits. On average, home buyers deal with around 4-5% of the purchase price in transaction costs. When selling, the costs go up even more—reaching 8-10%. Altogether, think of it as a 15% hit to your profit right there, just from buying and selling.

If your profit margins are already slim, transaction costs can wipe out your gains.

How to Slash These Costs

Here are a few smart ways to bring down transaction costs:

• Negotiate fees like agent commissions.
• Shop around lenders to get the best closing deal.
• Use DIY skills for minor repairs. Instead of paying contractors before selling, spruce things up yourself—anything from painting to fixing minor issues.

A good way to reduce these costs is by wearing multiple hats. If you’re handy or have the time to manage some of the work, you’ll reduce the “little buggers” that eat into your margins.

Bringing It All Together

Mastering rental real estate isn’t just about finding properties and crossing your fingers. There are simple rules like the 55% rule and key metrics such as cap rates to guide you on what properties are worth chasing and which ones you should walk away from.

Here’s how you win:

• Focus on Price: Stick to fair or below-market properties.
• Make Larger Down Payments: You’ll sleep better at night knowing you’re not cash-flow negative in the long run.
• Slash Those Transaction Costs: An endless flow of fees will eat into your profits unless you stay vigilant.

Keep those strategies in mind, and rental real estate doesn’t have to be intimidating—it can be a fantastic way to build regular, semi-passive income for your future.

 

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