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SHOW NOTES FOR EPISODE 550: THE BASICS OF REAL ESTATE INVESTMENT ANALYSIS
Investing in real estate can be a great way to save for retirement and earn monthly cash flow. However, it’s critical that you do a thorough investment analysis first. before you purchase any prospective investment property. In today’s podcast, Bill outlines the key analysis elements every investor needs to know to assess a property’s potential profitability.
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The Basics of Real Estate Investment Analysis
Investing in real estate can be a great way to save for retirement or earn monthly cash flow, but it’s critical that you do a thorough investment analysis first before you purchase any prospective investment property. Knowing a property’s potential or lack thereof can help you decide if it’s the right choice.
Investing in real estate means more than just finding an attractive property, buying it, and finding renters. In a perfect world, that may work, but in reality, many other factors determine if your investment will work out the way you planned or be a complete flop.
Before you invest in real estate, consider learning how to do investment analysis first.
The Most Important Numbers You Need
To conduct a property investment analysis, you’ll need information about the property itself, including its income and expenses.
Here is the Basic Property Information You’ll Need to Know
The Property
You should know:
- Property size (total square footage)
- Land size (square footage, acres, meters, etc.)
- Features
- Condition (does it need renovations, repairs or repositioning)
Property Income
If the property was already an investment property, get as much information about the potential income as possible.
- How much rent did the property bring in monthly? (breakdown by bed or by room, by apartments, etc.)
- How often was the property vacant?
- Did the property produce any other income?
Expenses
Rental properties cost money to operate. You are the landlord, so you are responsible for the cost of everything. Find out as much as you can about the costs, including:
- Maintenance costs
- Repair costs
- Utility expenses
- Real estate taxes
- Homeowner’s insurance premiums
Purchasing and Financing
You must also know the cost to purchase and finance the property if applicable. How much is the seller asking? How close is it to the appraised value?
How much will financing cost if you need to borrow the funds? Does the property need renovations/repairs/upgrades, or can you rent it as-is?
Are you employing a “value-add” strategy where you improve, rehab, and/or update the property to increase the value?
Where to Find Property Information
You need a lot of information to evaluate a property, but where do you find all the data you need?
Are there city, county or state records available?
If you’re more of a DIYer, you can find the property information in a few places:
- Seller – The seller should be able to provide you with a wealth of information, especially information about the property itself. If you’re buying from another investor, they should have information about the income and expenses too. Don’t rely too heavily on the information they provide you unless they provide proof. Sellers have motivation – they want to sell the property so that they may inflate the numbers slightly.
- Inspector or Appraiser – You’ll invest a little money upfront, but knowing a property’s condition and what it needs is important before you buy it. A professional inspector or appraiser can tell you if a property is worth investing in or if it will cost too much.
- Your Lender or Bank – If you’re financing the property, talk to your lender or bank about the costs. Know the upfront costs, like origination fees, title search fees, and appraisals, as well as the back-end costs, like interest and mortgage insurance.
- Property Management Company – If the seller used a property management company, you could get hard data from them, so you know you’re dealing with ‘real’ numbers and not inflated numbers. The management company can tell you how much income the property brought in and the average expenses.
- Should You Use Estimates or Actual Data? – Estimated numbers can help you form an opinion about a property, but you shouldn’t use them to make actual decisions.
A seller can tell you around how much income a property earned or how much it cost, but until you have concrete data, don’t decide to purchase or pass on a property. Sellers may inflate numbers to make the property look more attractive or make mistakes, making it look less attractive without realizing it.
Having numbers, you can use to make decisions is critical.
If a seller says it generates $6,000 per month, compare the rents to a bank statement that verifies monthly funds going in and out. You can check both income and expenses this way.
Assessing a Property’s Potential
Once you have the numbers, it’s time to do some number crunching to determine a property’s true potential. Here are the calculations you should consider.
- Net Operating Income – Net operating income is a universal metric – most investors use it to decide if a property is worth it. NOI is the income left after expenses, excluding any loan costs. In short, it’s the property’s total income minus expenses.
- You can look at NOI monthly or as an annual number by multiplying the monthly NOI by 12.
- Net operating income is universal because it doesn’t include debt servicing. Since each investor would have different debt servicing numbers, it’s impossible to determine NOI across the board. If you want to make a fast decision, looking at NOI can help you decide if a property is worth considering.
- Cash Flow – Cash flow is similar to NOI, except it considers all expenses, including debt servicing. Cash flow simply is the income minus expenses, but it gets more detailed than just looking at the rent (income) and mortgage (expenses).
- Each property has different expenses, but here are the common expenses:
- Mortgage payment(s)
- Real estate taxes
- Homeowner’s insurance
- HOA dues
- Maintenance costs, including lawn care and snow removal
- Repairs
- Utilities (that you cover)
- Property management fees
- Cash flow is individual and depends on the type of financing you can get and whether you’ll use a property management company or manage the property yourself. The more expenses you have, the lower your cash flow and vice versa.
- Cap Rate – The cap rate is another ‘non-biased number buyers can use to generalize if a home is right for them or not. While each area has a ‘good’ and ‘bad’ cap rate, on average, a cap rate between 8% – 12% is good.
- But what is the cap rate?
- It’s the NOI/Property value.
- Since it uses NOI, it’s independent of any financing or debt service on the property, giving you a general idea if it’s within the range you want or if you should look elsewhere.
- The cap rate is the return you’d earn if you didn’t finance the property. It’s an excellent way to determine if the property is a good investment for you. If you aren’t sure if a cap rate is good or bad for the area, look around, finding out the cap rate for other properties. Once you know the average rate for the area, you can determine if this property is worth it.
- Total ROI (or Return on Investment) – Your total ROI is your total return on investment. Again, a good and bad ROI differ for each person, but you should have a number in mind.
- Your ROI is your total return/amount invested.
- Your total return should include all factors such as taxes owed or paid, equity earned in the year, and property appreciation. You can use numbers provided by the seller or data you found to calculate your potential ROI to see if it fits within your guidelines.
- Cash-on-Cash Return – Your cash-on-cash return helps you determine if investing your cash in a home is the right choice or if you’d make higher returns elsewhere.
- You know the returns you’d earn if you invested in a CD or even the stock market, or at least an average. You can use those baseline numbers to see if investing your cash in the property makes sense or if you’d have a higher rate of return investing elsewhere.
- Calculate your cash-on-cash return with this equation: Cash flow/Investment made
- Your cash flow is all cash you bring in for the year on the property, and your investments are the money you paid out to invest in the property. Your cash outflow may include the down payment, rehab costs, taxes, insurance, and closing costs.
Other Factors To Consider
In addition to crunching the numbers, you should think about real estate investments logically too. Ask yourself the following questions:
- What do you know about the area?If nothing, then do your research. Find out the school ratings, crime rates, and the overall feeling of the area. Are there enough amenities? Is the area for families or singles?
- How will you finance the property?You can’t invest in a property if you don’t have the money. How will you finance it? Can you get approved?
- Does the property need renovations?Know what you must invest in a property before you can rent it out. Is it in total disarray, or just need a little work? The money you lay out to fix the home will affect your analysis.
- How will you manage the property?Did you know you don’t have to only invest in your local area? You can even invest out-of-state. Then you hire a property management company to handle the property for you, and you have a passive investment in real estate.
- Do you have the money to maintain the home?Before you invest in real estate, make sure you have a decent financial cushion or reserves account. Even if you hire a property management company, the cost of all maintenance and repairs falls on your shoulders.
Getting Help To Analyze Real Estate
It can feel overwhelming to analyze real estate. There are a lot of numbers and not many places to find the numbers. If you rely on sellers, you may be looking at skewed figures and go into investment thinking you’ll make more than you will.
But if you do the work yourself, it can take up all of your time, and you still may not have the correct answers. The key is to get the right level of support.
Their professionals do all the due diligence for you, including inspecting and appraising the property. They cover every bit of information you could need to decide if a property is right for you. They even include analyses, graphs, and pictures, so you know for certain where you stand.
Final Thoughts
Don’t buy a house without analyzing its potential. While no one can predict the future, you can use historical and current data to hypothesize how a property will perform moving forward.
Knowing as much detail as possible about a property, the area, and its potential will help you make suitable investments. While some factors are personal and/or unknown, there are enough factors available to help you determine where and how you should invest your money.
References:
https://finance.yahoo.com/news/introduction-real-estate-investment-analysis-154903172.html
Podcasts:
373: Rental Property Analysis Simplified with Frank Gallinelli
036: Analyzing Rental Properties – Part 1
040: Analyzing Rental Properties – Part 2
042: Analyzing Rental Properties – Part 3
024: What is Cap Rate and Why is it Important?
154: What is a Good Cash-on-Cash Return?
198: What is a Good ROI for Your Rental Property?
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