Most new real estate investors don’t spend much time analyzing their potential investments. Mostly, they just follow their intuition while choosing a deal and don’t really analyze the numbers. There are many fancy words associated when it comes to deal analysis e.g. NOI, cash-on-cash return, cap rate, and total return. This analysis needs to be properly understood before one can move forward with real estate investing. Thorough knowledge of market comparisons and property comparisons is the key to success in real estate investments.
We require a different level of analysis for different sized properties, be it a residential one or a commercial one. There is different analysis for multi-unit residential properties and duplexes or complexes. The analysis mentioned is good for even a single-family rental property as well as multifamily.
Determining the value of your real estate investment
Every property is valued differently, depending upon various factors. So you cannot assess all types of properties in the same way because it might lead to a wide range of values.
To determine the value of single-family homes, we use market “comparables”. Comparables are actually the neighboring properties that have parallel characteristics e.g. number of bedrooms and bathrooms, floorplan, garage size, and other amenities. A general rule is that a single-family investment home will rise in value when a comparable home`s value rises and falls when the neighboring comparable home`s value falls.
These are larger as compared to single-family homes and have at least two units. These types of investment properties are priced differently. The value of such property usually is determined by how much income or profit the property yields. So in multifamily property, it’s possible that the value of your property is increasing even though the neighborhood prices are decreasing. So, a thorough real estate investment analysis is very important. For such an analysis, there are many primary factors to consider, out of which the most important are cash flow and appreciation. Cash flow can be defined as the money left after paying all the bills, while appreciation is the equity gained by the increasing value of the property.
Gathering your information
For a good financial analysis, one needs to input some information into a related financial model, then using its calculations for determining the pros and cons of the investment. Following are some of the variables for a detailed residential rental property financial analysis:
Property details like the number of units, area, and design.
Purchase information such as costs incurred on purchase.
Financing details: which contain loan or mortgage information.
Income: Rental value or any other income yielded by the property.
Expenses: including maintenance costs, insurance, and property taxes.
Pro-forma vs. actual data
In order to get good data from your model, you need reliable and accurate information. You can be misled by the seller by providing appealing numbers which are not usually accurate as they tend to hide maintenance charges, taxes, etc in order to lure buyers by high rental income estimates. So an investor makes sure that you are provided with the best available information. Pro-forma is actually the data provided by the seller which you have to check for accuracy by getting your hand on tax returns, property tax bills, and maintenance records.
Where to find data
Property details can be obtained from the seller or local records office.
Purchase information can be obtained by getting the property inspected to make sure that there are no hidden issues or problems.
Financing details can be obtained from the mortgage broker.
Income details obtained from the seller or the property management company which is currently dealing with the property.
Expenses These should be obtained from the seller or property Management Company. For major repairs, check with a building inspector.
Elements of real estate investment analysis
Given below are the key elements of the real estate deal analysis
Calculating net operating income
A very important aspect of financial analysis is “net operating income” (NOI). This can be defined as the total income any property yields minus all expenses. NOI is usually calculated monthly using the data available of income and expenses. This can be easily calculated for the whole year by a simple multiplication by 12.
Assessing property income
The total income of any property is called its “Gross income”. This includes rents well as other income from amenities like parking. Tenant rent contributes the most to gross income, so we need to consider this while including a unit vacancy in the overall property analysis. Your property`s vacancy rate may not be in accordance with the average local vacancy. For that, you need to check if you have the correct data and property management`s efforts to keep it filled at the required rate. Typically your income would be equal to your expected income minus vacancy income. The percentage of vacancy needs to be calculated and then can be used in the analysis.
The next step is to calculate total expenses for your property. Expenses normally have the following subcategories: Property taxes, Maintenance (can be estimated by the condition of the property), Insurance, Advertising, Management, Utilities Landscaping, Utilities which may be paid by owners. It’s quite difficult to estimate repairs due to their variable nature. Normally repairs are estimated at 5-15% of the rental value, but it does depend greatly on the property`s condition and age. Another expenditure is capital expenditure (CapEx) which is defined as the big chunk of expense that needs replacement regularly e.g. roof repairs, appliances repairs, or replacement. This can be incorporated by estimating the cost of repair and dividing it by the remaining life of that particular item and setting that amount aside. If you have a property management company looking after your property, you have to keep that expense in mind as well for the analysis.
NOI can be calculated by subtracting the total annual expenses from the total annual income. This figure is further used in the real estate analysis that we want to make. NOI doesn’t incorporate the cost of the loan. NOI typically gives the income a particular property produces which is independent of the financing by the owner. NOI is property specific income metric.
Common real estate performance measurements
How do you measure the performance of your real estate investment? Well, you can measure the performance by understanding these numbers.
It can be defined as the amount left after all the expenses are paid. There are quite a lot of items that come under expenses like insurance, debt(according to the financial plan), HOA. It determines the total annual profit. If you don`t have any loan for a specific property, your cash flow and NOI are equal.
Rate of return
For running a good analysis, the rate of return(ROI) also needs to be considered. It can be defined as cash flow relative to the cost of investment.
Capitalization rate (or cap rate)
Cap rate is an impartial figure which is not dependent upon the buyer or their financing. This makes it a perfect indicator of a property`s potential return. It can be defined as NOI over property price. It is considered to be a very important figure in real estate investment analysis. The cap rate can easily be called the ROI f you paid all cash. Larger properties can be valued based on the cap rate of similar investment properties.
Cash-on-cash return (COC)
The cash-on-cash (COC) return is reliant on financing. It is directly related to the cash you spend on the property. By definition, it is the cash flow over an investment basis. The rate of return considered ideal varies from investor to investor. It is a general rule that if you are getting an ROI of less than 10%, it`s not a good idea to invest in such a property.
Some of the other important items to consider in your real estate investment analysis are Tax consequences, Property appreciation, Equity accrued. The difference between Total ROI and COC is that the later just consider the financial impact of cash flow while total ROI considers which may affect your take-home income. Total ROI can be defined as a total return over investment basis.
The real estate investment analysis covers the beginning year when you own the property. A lot of factors including accrued annual equity, inflation, rental rates, and tax situations change. One needs to extend their analysis over a few years using trends and survey data which can help in predicting the direction of your local market.