How To Choose Your First (Or Next) Investment Property
We’re probably not the first ones to tell you that investing in real estate can be a great way to grow your wealth over time. It’s estimated that about 40% of a millionaire's assets consist of real estate, a clear indication of the tremendous potential it holds.
If you're in a location like here on Oahu, with illustrious beaches that attract people from all over the world, the potential gains can be even greater. Plus, the benefits go beyond the equity you’ll build, offering opportunities for passive income, tax advantages, and greater stability than many other investment options.
However, not all properties are created equal, and it’s important to know how to identify a good investment before making a purchase. Whether you're a seasoned investor or just getting started, this blog is packed with valuable insights to help you make an informed decision on your next (or first) investment property here on Oahu. I’ll even share with you how I use just one equation to instantly determine if an investment is good or bad.
Where Should My Investment Property Be Located?
The location of a property is the most important factor to consider when purchasing any kind of real estate investment. A location that is in high demand for rentals means that you are more likely to find tenants quickly and easily. For instance, properties located in areas near schools like Makiki, business districts like Downtown, accessible public transportation like Kapolei or even military installations like Kailua and Kaneohe, are likely to have a steady flow of potential renters. This strong demand often translates to higher rental rates and reduced vacancies, allowing you to maximize your return on investment (ROI). (You can also check out our blog on affordable neighborhoods for more insights in selecting the right location.)
The location you choose can also impact the appreciation of your property's value. Properties located in desirable neighborhoods (like Waikiki) or in areas with potential for lots of development (like Kapolei or Kakaako) are more likely to experience drastic increases in value over time. This can result in higher resale values and greater profits when you choose to sell your property down the road.
What Condition Should I Look For?
Another crucial factor to consider is the condition of the property. The level of repairs and maintenance required can vary based on your experience level and future goals. If you're primarily looking to generate rental income, you should seek out properties in good condition that require minimal repairs. That’s not to say the unit you target needs to be fully remodeled with state-of-the-art appliances; the unit can be older, just pay special attention to the property inspection report to make sure it has been well-maintained over the years.
On the other hand, if you're purchasing a property with the intention to remodel and flip it for a profit, an already well-maintained home won't provide enough opportunities for upgrades and value addition. In such cases, it would be preferable to find a property that needs some TLC so you can transform it and demand a higher price when you sell. However, be cautious not to take on renovation projects that exceed your budget (you don’t want to end up on one of those “Nightmare Renovation” shows on HGTV). By considering the property's condition coupled with with your investment goals, you can make an informed purchase that aligns with your financial aspirations.
How Much Can I Expect To Make?
When it comes to generating income from rental properties, the potential returns can be quite attractive. For instance, a one-bedroom unit in Honolulu can generate an average monthly rental income of around $2,145, while a two-bedroom unit can fetch an average of $2,877 per month (according to MLS over the last 180 days). Additionally, short-term rental options like those found at hotels can provide even higher rental rates in well-traveled tourist destinations.
The actual income you can expect to make ultimately depends on several factors unique to each property, such as the property's condition, location, and rental demand. Do some research to see what homes are being rented for in the area, paying special attention to the ones that best match your target property. For condos and townhomes, it’s best to look for comparable properties within the same complex, as other buildings may offer different amenities or layouts that could skew your results. Information on renting can be hard to find online, so collaborating with a knowledgeable real estate agent who specializes in the local market can provide you with valuable insights and help you determine a realistic income projection for your investment property.
How Much Will I Have To Spend?
When investing in real estate, it's important to budget for the various reoccurring expenses associated with owning and maintaining your property. Understanding these expenses will help you accurately calculate your true profit potential and determine if you can generate positive cash flow. Here are some key expenses to keep in mind:
Regular maintenance is essential to keep your property in good condition and attract reliable tenants. This includes routine repairs, landscaping, and repainting. Some people choose to do this work themselves to save money, but I’ve found that most of our clients end up budgeting for handymen to carry out these tasks.
Similarly, if you prefer a more hands-off approach or don't have the time to handle day-to-day management tasks, hiring a property manager can be another item worth budgeting for. Property management services typically include tenant screening, rent collection, property inspections, and handling maintenance requests. While this service comes at a cost (typically 8-10% of the monthly rent), it can save you time and effort in managing your investment property effectively.
Depending on where your property is located, you may be responsible for paying certain utilities, such as sewer, electricity, or gas. Savvy investors often include these utility fees in the monthly rent to help offset their costs.
Protecting your investment property with appropriate insurance coverage is essential. The cost of insurance will depend on factors such as the property's location, size, and the coverage you choose. Thankfully, Hawaii’s home insurance rates are significantly lower than the national average, so shop around and review different insurance options to ensure you have adequate coverage at a reasonable cost.
Property taxes are yet another expense that all homeowners have to pay. The amount you pay in property taxes is determined by the assessed value of your property multiplied by the local tax rate, which in this case would be 0.35% (incredibly low considering how expensive homes on Oahu can be).
Finally, the State of Hawaii requires a general excise tax (GET) of 4.712% on all rental income generated from investment properties. Keeping all of these expenses in mind, you’ll be able to figure out just how much money you can expect to net every month your unit is rented.
How Often Will My Unit Be Vacant?
When investing in real estate, it's important to consider the potential vacancy periods for your property. Vacancy refers to the times when your property is unoccupied and not generating any rental income. While it's ideal to have your property rented out at all times, vacancies are a reality that investors must prepare for.
Vacancy periods can vary depending on market conditions in your area, but you can reference the Honolulu average for rental vacancies which is 6.5% as of February 2023 (according to Point2Homes). Additionally, 2-bedroom rentals in Honolulu spend an average of 35 days on the market, so you’ll want to start looking for new tenants before the current lease ends to mitigate your losses during the turnover.
It’s also worth mentioning that some scheduled vacancies can be a great opportunity for you to handle any lingering repairs or renovations that could net you a higher rental rate from your next tenant. It’s always recommended that you set some of your profits aside each month in order to comfortably pay for these value adding ventures.
What Is Net Operating Income (NOI)?
In order to contextualize the income you expect to receive, while keeping in mind the expenses and periods of vacancy, real estate investors use net operating income (NOI). Net operating income is a metric that provides a clear picture of a property's profitability before considering financing and tax implications. Basically, it helps investors determine if renting a particular property is worth the costs associated with owning and maintaining it.
NOI is calculated by subtracting the operating expenses and vacancy allowance from the total income generated by the property. The operating expenses that we touched on earlier typically include property management fees, maintenance costs, property taxes, insurance premiums, utilities, and any other expenses directly related to the property's upkeep. It's important to note that mortgage payments and tax implications are not included in the NOI calculation, as they are considered financial expenses. You may still want to consider these expenses before making a purchase, however, NOI is intended to be used as a metric for all investors to gauge properties evenly, regardless of how they might choose to finance them.
Let’s use this property in Kapolei and work through how to calculate it’s NOI. First, we need to find out how much rental income we expect it to generate every month. Looking back at some units that were rented out, it looks like our subject property could rent for about $2,400 per month.
Next, we will need to calculate its operating expenses. For the property taxes, we can see it’s $120 per month. Insurance we can estimate being around $300 for a unit of this size. This complex only includes sewer and water in the utilities, so we will need to account for things like electricity ($200), internet and cable ($150). Property management would be 10% of the monthly rent (0.10 x 2,400), so $240. The maintenance fee is $784 per month. Finally, the 4.712% GET tax on your rental income would come out to $113.09 (0.04712 x 2,400). Our grand total for operating expenses is $1,907.09.
(120 + 300 + 200 + 150 + 240 + 784 + 113.09) = $1,907.09 Total Operating Expenses
Lastly, before we can calculate NOI, we need to find our vacancy allowance. Honolulu’s average rental vacancy is 6.5%, so this calculation should be pretty easy.
(0.065 x 2,400) = $156 Vacancy Allowance
Now, to calculate NOI, we subtract our operating expenses ($1,907.09) and vacancy allowance ($156) from our monthly rental income ($2,400).
(2,400 - 1,907.09 - 156) = $336.91 Monthly NOI
Keep in mind, we can fine tune this NOI to our liking by having the tenant pay for some items or even managing the property ourselves. Ultimately, if the NOI for this unit is much lower than we would like, we should move on to the next property.
What Is Capitalization Rate:
Now that we’ve calculated the NOI, we can at last move on to the capitalization rate, or cap rate, which is the most commonly used metric that investors turn to when analyzing their purchases. The cap rate, expressed as a percentage, provides valuable insights into the relationship between a property's net operating income (NOI) and its market value. By taking the property’s market value into account, the cap rate helps investors solidify their assessments of the property's potential rate of return. A higher cap rate indicates a higher potential return, while a lower cap rate suggests a lower return. To calculate cap rate, divide the NOI from our example by the current market value of your target property.
Residents on the Mainland are used to seeing properties with cap rates around 7-9% in their local areas. Here on Oahu, on the other hand, 4% is considered a good cap rate, while properties north of 7% are fairly hard to come by.
Using the same example from earlier, let’s walk through how to calculate this property’s cap rate, and breakdown the rate or return we can expect to receive. Cap rate is an annual metric, so we will first need to multiply the NOI we already calculated ($336.91) by 12 to get the annual figure.
(336.91 x 12) = $4,042.92 Annual NOI
Then, we need to divided that by the current market value of the property. Since this property is currently for sale, we will use their list price as the market value ($500,000).
(4,042.92 / 500,000) = .00081
Since cap rate is a percentage, we will just multiply our result by 100 to get our cap rate.
(0.0081 x 100) = .81% Cap Rate
Now that we have our cap rate, we can fully interpret how our investment in this property could look from a financial standpoint. With a cap rate of .81%, for this $500,000 investment townhome, we can expect a yearly return of $4,050, which means we are making a profit, but realistically we could find a much better investment.
(500,000 x .0081) = $4,050 Annual Return
But hey, depending on your situation, a property with a .81% cap rate and a yearly return of $4,050 may be exactly what you’re looking for. After all, that’s 4 grand more than you would’ve had, not to mention that someone else is paying the bulk of your expenses for your investment property. Things could be a lot worse!
Choosing the right investment requires careful consideration and evaluation of various factors. From the location and condition of the property to understanding potential income, expenses, and market dynamics, every aspect plays a crucial role in determining the success of your investment. By conducting thorough research, collaborating with experienced professionals, and staying informed about the local market, you can make informed decisions that align with your financial goals.
Remember, real estate investment can provide opportunities for wealth accumulation, passive income, and long-term growth, but it also comes with risks. As you embark on your journey as a real estate investor, continue to expand your knowledge, adapt to market changes, and seek guidance from trusted experts. With the right approach, your next real estate investment on Oahu can be a stepping stone towards building a robust and profitable portfolio.
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