Investing in real estate is something that’s impossible to do well unless you’re able to compare different opportunities. Otherwise, how will you figure out what you’re going to opt for? This guide for beginners will outline everything you need to know to carry out a comprehensive analysis and make the right decision.
Valuing different property types
One of the first questions to ask yourself is the type of property you’re valuing — this will lead to different considerations. Above all, there are huge differences between single-family homes and multi-unit properties.
The valuation of single-family properties mostly depends on how they compare to similar properties nearby, whether they’re homes or investment purchases. Similarity here comes down to factors such as the number of bedrooms and bathrooms, backyard and garage size, and the overall size and floor plan.
Yet when it comes to large, multi-unit investment properties, the analysis becomes more complex — and the more units the property has, the truer this becomes. Just because other homes in the neighborhood a property is situated in are dropping in value, it doesn’t mean that the investment becomes less profitable. Instead, this will come down to both the property value’s appreciation (or depreciation) and the cash flow, or the balance between costs and income.
We’ll be focusing on cash flow and related elements or the rest of the article since it’s much more tangible since value appreciation relies on predictions that may not be accurate.
Collecting financial data
To estimate cash flow or other financial information related to a property, you need to identify the most relevant aspects and plug them into a model. Let’s run through some of the most crucial variables:
- Property information: Such as square footage, number of units included, and design.
- Income: From rent payments or other sources.
- Mortgage or loan information: Including total amount, interest rate, down patent, and closing costs.
- Purchase expenses: Purchase price and any renovation costs.
- Expenses: Including maintenance, insurance, and property taxes.
However, be careful about where you get info from all of the above.
Good data: Real vs. pro-forma
To get a good estimation of your real estate value, you’ll need accurate data. Yet sellers often provide exaggerated, too-good-to-be-true estimates that don’t reflect the whole picture. These estimates are known as pro-forma data.
Be sure to seek out past financial data over optimistic estimates, such as past tax returns or maintenance records. Also, take a cautious approach if those past records are from a long way in the past.
For all the variables we outlined above, this is where you can get the data needed:
- Property information: Directly from the seller or from the local records office.
- Income: Directly from the seller or property management company.
- Mortgage or loan information: Mortgage broker or lender.
- Purchase expenses: Property inspectors.
- Expenses: Directly from the seller or property management firm.
Aspects of real estate investment analysis
Now we’ve covered the basics of the theory behind real estate investment analysis, it’s time to get onto the real thing. Let’s go through a property analysis in which we have the following information:
- Cap rate
- Gross income
- Net operating income
- Other income
- Advertising costs
- Vacancy rate
Net operating income
Net operating income is the difference between the total income the property brings in minus the total expenses (including the home loan itself). You can find this by looking at monthly income and expenses.
Gross property income mostly consists of tenant rent, but it can also come from other sources, such as parking or laundry. You may also want to account for the property’s vacancy rate since it’s unlikely all blocks will be present at any given time.
Then, you can find your total income by subtracting money lost from vacancy from the income expected.
In addition to the expenses caused by vacancies, properties face plenty of other expenses. Make sure you don’t miss out on any of the following: Advertising, landscaping, maintenance, insurance, property taxes, utilities (if the owner pays them), and management (if you work with a property management company or an individual manager).
You’ll most likely find these fees on a monthly basis, but you can then convert them to an annual equivalent.
It can be more difficult to figure out how much you’ll need to spend on things like repairs and capital expenditures (aka big-ticket items like replacement roofs), so you may need to rely on estimates here. We recommend assuming you’ll spend about 10% of your total rent on repairs and, for capital expenditures, to put aside an amount equal to the repair cost of an item divided by its remaining lifespan.
Finding net operating income
Once you know the property income and expenses, it’s easy enough to bring them together and calculate net operating income.
Then, you can cast your attention to other elements of real estate investment analysis.
Real estate performance measurements
Net operating income isn’t the only way to quantify the performance of a real estate investment property. Here are a few more metrics to consider.
Cash flow is usually calculated as the difference between income and expenses, but be careful not to simplify what you include. There can be all kinds of income sources and costs associated with properties, as we’ve examined in this article.
Unlike net operating income, cash flow should include debt service as an expense, making the amount you get from this calculation your total annual profit. Did you know a Cash-Out Refinance can alleviate cash flow problems?
Rate of return
Return of return, or return on investment, is the cash flow of a property divided by the cost of the investment. Ideally, you’d be looking for a number of around 8% or more to try and beat other investment sources, such as the stock market.
Also known as cap rate, this number is useful for figuring out the potential profitability of an investment property. To find it, divide your net operating income by the property price — meaning you’ll get a figure that represents the returns a property would have earned if you’d bought it in cash.
Although cap rates vary between areas, you’re unlikely to get anything above 9-12% — and look at the average cap rates for properties in the area.
Cash-on-cash return is another way of estimating a real estate investment property’s returns. However, this time, it depends on financing (or rather, how much cash you put down).
You find it by calculating cash flow over investment basis. And once again, you should aim for a return of around 10% (or more).
Total return on Real Estate Investment
Unlike the rate of return measure examined above, you can calculate total return on investment by dividing total return over investment basis. This way, it accounts for now just cash flow but all aspects of revenue — including appreciation, equity, and tax impact (which could be a loss).
Ready to get to work?
As you can see, real estate investment analysis is a complex task that involves all kinds of factors. Plus, this article has only considered calculations in the first year of property ownership — as time goes on, there will be even more aspects to consider, such as inflation, changing tax policies, and accrued annual equity increases.
There’s no way of knowing what the future holds, but we can make the most of the figures at our disposal to identify trends.