Analyzing whether a piece of real estate is a good investment requires taking a number of factors into consideration, including whether the property is a single family home, a multi-unit rental, or a commercial building. In general, however, the following information is a good starting point for analyzing the value of a real estate decision.
Single Family Homes
Analyzing the purchase of a single family home, especially if you plan to live in it, is usually simpler than analyzing rental and commercial property. The major factors to take into consideration are the market values of similar homes in the same area, how the price of the home relates to those comparable houses, and whether those houses in that area are generally rising in value.
Real estate agents often use the word “comps” as shorthand for “comparable” houses in the area. Comparable houses are not, however, just the other houses in the neighborhood. They must be as comparable in characteristics as possible to the house under consideration. The following characteristics make for good comps: similar floor plan, roughly equivalent square footage, same number of bedrooms and bathrooms, similar garage size, and other amenities such as yards and driveways.
Most real estate agencies compile comps for the houses they have listed, but these should be checked for accuracy. Once a legitimate set of comps is determined, then you should look into whether the value of the comparable houses are rising or falling. This is most accurately determined by getting information from the relevant property tax office.
Analyzing the value of larger properties, especially rental properties, is much more complicated, but crunching the numbers fully and carefully is vital if you want to be confident in the decision you make.
The first difference between analyzing larger rental properties and analyzing single family homes is that the set of comps for a larger property is not as good an analytical tool as it is for single family homes. Essentially, this is because the value of larger and commercial properties relates to how much income it produces over time, not the prices of similar buildings in the area. An apartment building could be a good income investment even in an area where house prices are dropping, especially if other aspects of the neighborhood are more apartment-friendly than house-friendly (proximity to colleges, a young, professional population, etc.) While this variability may be a strength, it also means that analyzing the detailed financial aspects of the investment becomes even more important than a single family home.
The following analytical model is based on multi-unit rental property, but the general principles hold for other types of investment real estate, including commercial property.
Gathering Information and Financial Data
First you must collect the essential information and financial data about the property that will affect your decision. Here are the five categories of essential information.
Property Details: the physical design, square footage, number of units, provision of utilities, etc.
Purchase Information: the purchase price plus the price of essential improvement or rehab work needed to the property.
Financing Details: the total loan amount, down payment amount, interest rate, closing costs, etc.
Income: the income the property produces through rent.
Expenses: the costs of maintaining the property, taxes, insurance, and repairs.
You must get the most reliable and accurate data possible in order for your calculations and analysis to work in your favor. This brings up the important difference between Pro-Forma Data and Actual Data.
Pro-Forma Data and Actual Data
Pro-Forma Data is the information about the property given to you by the seller during your initial discussions about the property. Generally speaking, sellers want to put the most positive spin they can on the property they are selling. This does not mean that sellers are lying so much as they are likely to present the best numbers within the range of the category you’re discussing. For instance, a seller may give you a rental income estimate at the high end of the scale. They might low-ball the property’s maintenance costs. Despite its likely degree of inaccuracy and its “best case scenario” feel, pro-forma data can still be useful. Once you apply filters to what the seller tells you, it might become obvious that the property is not the right investment for you. If a property doesn’t fit your financial goals even with the most positive pro-forma spin on its investment value, you can save a lot of time by ending the discussion about it and moving on to consider another property.
If the pro-forma data is more or less acceptable, it is time to start gathering actual data (“the actuals”) on the property from official sources. The seller should be able to provide you with tax returns from previous years, property tax bills, and records of the maintenance and upkeep of the property. But for the purposes of your analysis of the property, you may need more accurate information. If the property hasn’t been assessed for taxes in a while, then it’s possible that its taxes will be much higher at the next assessment.
Even after gaining data from official sources, you may find that the “actuals” on the property may not have risen that much. It’s still essential to run each number through the following calculations because even small increases in certain numbers may affect your income and profits greatly over a number of years.
How to find the Actuals
Property Details: start with the seller’s information. Then get more comprehensive, detailed, and official date from the local County Records Office.
Purchase Price: This seems almost too obvious. The seller is going to ask for a certain amount, you’re going to negotiate, and eventually you’ll agree on a selling price. You should be careful to consider any immediate work or repairs that the building may need. Have the building inspected by a professional building inspector. This is the best money you’ll ever spend. A quality inspection may find things that warn you off the deal and end up saving you lots of heartache.
Financing Details: Your lender or mortgage broker will give you an idea (or even better a letter of approval) about loan costs and the amount of the down payment. They often insist on a building inspection.
Income Generation: The seller should have accurate information about this and, as long as they provide you with previous year’s tax returns, you can be confident in its accuracy. If a property management company is running the property, they will also have income records that can provide an excellent check on the seller’s information.
Expenses: Expenses should also come directly from the seller, but make sure that it is not pro-forma data. Tax returns and official business records will provide you with the actual data. Don’t forget to add in the expenses that the building inspector tells you are necessary.
This analysis of a sample apartment building puts actual numbers to the categories mentioned above. Usually, this information will come to you in the form of a flyer created by the current owner or a real estate agent.
Duplex in Quiet Neighborhood
Primary Type: Multi-Family Residential Garden-Style Low-Rise
No. of Units: 2
Cap Rate: 9%
Year Built: 1943
Lots Size: .25 Acres
Two-unit, all brick construction, just outside of downtown Pittsburgh. Two-story townhouse floor plans, hardwood floors, front and back entrances. Both units are occupied
This table shows pro-forma data similar to what a seller might provide.
|Financial Summary||Pro-Forma||Unit Mix/Rent|
|Gross Income||$19,200||2 2BR+2BT/$800|
|Other Income (Laundry)||$200|
|Net Operating Income||$15536|
Sample Financing for this Property
Remember that the information in the above table is just pro-forma data. You will need the actual data (the “actuals”) before signing any contracts. If you’ve done that, and spoken to your lender or mortgage broker, you may be able to secure a loan with the following details. (Remember, this is sample financing only.
- Price: $80,000 as listed in table above (or owner flyer)
- Finance Amount: 80% of total cost
- Interest Rate: Fixed 9% over 30 years
- Closing costs: 2% of total property cost
From these numbers, we can make the following Cost Assumption and Financing Assumption calculations. These calculations are crucial for later analyses about the profit value of the property.
|Cost Assumptions||Financing Assumptions|
|Closing Costs||$1,600||Interest Rate||9.0%|
|Total Cost||$81,600||Mortgage (Years)||30|
|Cash Outlay||$17,600||Mortgage Payment||$515|
With this sample building and this assumed financing, an accurate analysis of the viability of this property as a business.
Net Operating Income (NOI)
Net Operating Income (NOI) is one of the most important numbers used in real estate financial analysis. NOI is the total income generated by the property after all expenses have been deducted (not including debt service costs/loan costs). Normally, NOI is calculated monthly using income and expense data for that month. This makes it easy to calculate annual NOI by simply multiplying by 12. That sounds simple, but the gathering the necessary data for NOI is only part of the analysis.
Assessing Property Income
Property can generate income from different sources. Tenant rent is the most obvious, but your calculations should also include income from laundry facilities, parking fees, and miscellaneous income that the property will generate on a produce on a regular basis. The sample property above has 2 units renting for $800 per month.
Income calculations for any rental property must take into account the fact that some units will be vacant some of the time. Vacancy rates can be determined from the actuals given to you by the owner and by the rental property vacancy average listed in the area. When taking rental income into account, you should assume that your vacancy rate will never be lower than the average in your area. This conservative approach is safer than calculating a higher occupancy rate for your building. Further, make sure that you use a percentage value rather than a unit number. A percentage takes into account the different rents for the different sized units. The example building we’ve been using has a vacancy rate of 0%. Additionally, the laundry facilities generate $16.60 per month. There are no parking fees in this calculation.
Barring unusual circumstances, the gross monthly income for this property will be $1616.60 and the annual income would be $19,400.
When calculating expenses, it’s essential to list major expenses as well as seemingly minor ones (such as advertising). Minor expenses, if overlooked, can cut deeply into profits. We have listed the following common rental property expenses:
- Property Taxes
- Maintenance and Repair
- Management (if you hire a property manager)
- Advertising for tenants
- Utilities (if you plan to pay any portion of them)
Expenses for the Sample Property:
|Property Mgmt (DO IT YOURSELF)||(% of rent)||0%||$0|
The estimated total annual expenses for this property would be $3,864.
We can calculate NOI based on the total annual income and the total annual expenses using the standard NOI formula: NOI = Income – Expenses. In the case of the sample property, (Income) $19,400 – (Expenses) $3,864= (NOI) $15,536. The annual NOI figure of $15,536 is important for the more sophisticated calculations and analysis you will need for deciding whether to invest in the property.
Important Real Estate Performance Measurements and the ROI
Ultimately, a real estate investor should get an accurate ROI (Return on Investment) calculation to make a good investment decision. The NOI we just calculated now becomes a crucial factor in performance measurements that lead to a solid ROI calculation. These measurements are: Cash Flow, Rates of Return, Capitalization Rate, and Cash-on-Cash Return, leading to the ROI. The essential and crucial difference between the NOI and the ROI is that that ROI takes into account the debt service on the loan used to purchase the property.
Cash Flow is essentially the NOI minus debt service payments. Every real estate transaction has its own financial plan, and so the debt service payments will be different for each buyer (even on the same property). Once the debt service payments are taken into account, the Cash Flow figure will be the total profit the property generates for the year. The higher the debt service payments, the smaller the Cash Flow and vice versa. Obviously, if you pay the total price for the property in cash (i.e. you don’t take any loan), then your Cash Flow equals your NOI. (There are very good reasons not to buy an income property outright with cash, which are addressed below.)
From the financial data calculated earlier, the debt service on this sample property would be $515 per month ($6,180 annually). Therefore, the annual Cash Flow on this property would be $9,356. The calculation is $15,536 (NOI) – $6,180 (debt service) = $9,356 (Cash Flow).
Rates of Return
The rate of return (also known as return on investment or ROI) is one of the most important of calculations you need in making your real estate decision. Essentially, the rate of return is the amount of cash flow relative to (divided by) the cost of the investment (also known as your “basis”). The formula, therefore, is: ROI = Cash Flow/Investment Basis. Your Rate of Return will be high when your Cash Flow is high or your Investment Basis is low. When both of these things are true, your Rate of Return will be at its highest. For general comparison, the Rate of Return on a savings account is usually 4% annually, a CD is about 5%, and the stock market averages somewhere between 8-10%.
In order to determine the full Rate of Return/ROI for our sample property, we need three more calculations: the Capitalization Rate (Cap Rate); Cash-on-Cash Return (COC); and
Capitalization Rate (Cap Rate)
Just as the NOI is independent of the specifics of the buyer’s financing or potential financing, the Capitalization Rate (Cap Rate) is also independent of the buyer and the specific financing. The Cap Rate is as an important ROI value for our overall calculations. Here’s how to calculate it: Cap Rate = NOI/Property Price (Cap Rate is the NOI divided by the property price, expressed as a percentage). The Cap Rate may be the most important single number to use when analyzing the profitability of a rental property. Since the Cap Rate is independent of both the buyer and the type of financing, you could say it’s the most transparent and pure indication of what return the property will generate.
The Cap Rate for the sample property is calculated thus: NOI/Property Price = Cap Rate. $15,536/$80,000= 19.42%
Perhaps an easier way to think about it is that the Cap Rate is the ROI you would get if you paid straight cash for the property. It is, however, not necessarily the highest return that the property will generate. In the Cap Rate calculation, the investment about is the full price of the property (the maximum amount). Further, as we show above, as the investment amount goes down, the value of ROI calculations goes up.
Why do we need the Cap Rate, then? It’s perhaps the best way to determine whether the property will make a good return on investment comparable with other properties in your area. The other calculations we’ve used can’t tell you that. Most areas of the United States have maximum Cap Rates between 8-12%. But your area might be different. Once you find the comparable Cap Rates in your area (similar to finding comp prices on houses in the area), then you’ll know how profitable your property will be relative to its location. If the average Cap Rate in your area is high, say, for example, 10%, then you should only seriously consider properties that have a 10% Cap Rate. There are exceptions to this advice, though, if there are unique or complex situations related to the property you’re considering.
Cash-on-Cash Return (COC)
While the Cap Rate is a theoretical calculation, the Cash-on-Cash Return (COC) is a real calculation of the rate of return on a property. It’s called the Cash-on-Cash Return because the calculation is directly related to the amount of cash you put down when buying the property. COC is calculated like this: COC = Cash Flow/Investment Basis.
The COC for the sample property would be calculated as follows. The property’s annual Cash Flow was $9,356. The investment of cash we paid upfront (including the downpayment and the closing costs) was $17,600. Therefore, $9,356/$17,600= 53.16%
53.16% is considerably better than a standard savings account rate 4% and way better than a diversified stock portfolio rate of 8-10%. The major difference between these three types of investments (savings, stocks, and rental property) is that rental property usually requires a great deal of work by you (managing and repairing the property, collecting rents, dealing with problem tenants). Savings accounts and stock portfolios work on their own, without any serious effort from you. Therefore, rental property as an investment should have a COC of 10% or higher before you consider going ahead with it. Anything less than a COC of 10% on a property probably makes it not worth the effort compared to the stock market. And if you use a rental property management company, then your COC should be at least 11%-12%.
Just when you might be thinking that the COC is the last calculation you’ll need to make, we’re going to introduce the essential and crucial figure of the Total ROI.
Total ROI takes into account several other financial considerations that affect how a property will perform as an investment for you. These include Tax Consequences (depending on the rest of your financial portfolio, you may gain or lose money to taxes); Property Appreciation (this is not always easy to predict, but if you are able to get a reasonable fix on this, it’s a good number to have); and Equity Accrued (principal paid down).The Total ROI takes into account all the factors affecting your bottom line, whereas the COC only tells us the financial impact of Cash Flow on your return.
Total ROI is calculated thus: Total ROI = Total Return/Investment Basis. Total Return is made up of Cash Flow, Equity Accrual, Appreciation, and Taxes. For the example property, we’re going to put numbers on those elements in the calculation.
If we can expect a 2% appreciation on the value of the property, the dollar figure would be $1,600. The equity accrued in the first year of our mortgage is $437. For the sake of the calculation, we will assume that there are no tax breaks or extra taxes due for owning this property.
The Total Return for the sample property for one year would be: Total Return = $9,356+ $1,600+ $437+ 0 = $11,393. Then we can calculate our total ROI: Total Return/Investment Basis = Total ROI. $11,393/$17,600 = 64.73%. That’s a pretty impressive Total Return on Investment.
Financial Analysis Summary
While numbers and calculations are essential to any decision about purchasing an income property, other factors should be taken into account. In the first place, the analysis presented here is for the first year of ownership. In further years, accrued equity will increase, expenses will probably rise with inflation, rental rates may increase or decrease depending on your local market, the tax situation on the property may change, and there are bound to be some unpredictable factors that affect your return on the investment increasing or decreasing.
Smart investors will extend their analysis out over a few years, using whatever trend or demographic data you are able to obtain, especially those on the rental market and general inflation. Here is a full financial analysis of the sample property. We’ve assumed that rents will increase 3% each year, expenses will increase 2% each year. As you can see, the Cash Flow (and Rates of Return) on the property increase every year as well. This, then, could be a very good investment.