Let me ask you a question: How long do you spend picking out clothes each morning? 5 minutes?
Even if you’re the speediest dresser, you probably spend longer choosing your outfit than most investors spend doing the math for their real estate investments… Yikes!
Unfortunately, people choose their deals based on intuition, not analytics.
Ugh. Please, people!
Digging into the details of deal analysis might feel like a trip to jargon-town. Cap rate? NOI? Cash-on-cash return? Total return?
Feel bewildere? Well, we are here to help. Read this post, and you too could know how to analyze your real estate investments (and choose the best).
Determining the value of a real estate investment
Here, different properties are valued differently. Assessing a triplex the same way as a single-family home will lead you to a wildly skewed value. Here’s what you need to know:
Valuing single-family homes
Market “comps” — or nearby properties with comparable characteristics — determine the value of single-family homes. Investors look at variables like square footage, number of bedrooms and bathrooms, garage size, and amenities to find comparable homes.
A single-family home generally rises in value if similar homes are also rising in value in their area—and vice versa.
Valuing multi-unit properties
Larger investment properties—those with at least two units, and especially those with five or more—are priced and valued differently. The value is determined by how much income or profit the property produces. This is determined by many primary factors, but cash flow and appreciation are the two most important variables.
It’s possible that an apartment building in a neighborhood where the price of homes is dropping could, in fact, go against the trend and INCREASE in value! You can’t just compare your apartment building to others down the street to see how much it’s worth. That’s why real estate investment analysis is so important.
So to determine the value, follow these simple steps:
Step 1: Gather information
Good financial analysis involves inputting a bunch of information into a calculator and using the output to determine whether the investment is good or bad—and right for you.
Gather these variable for the most thorough financial analysis of your rental property investment:
- Property details: Number of units, square footage, construction date, etc.
- Purchase information: Total purchase expenses— aka purchase price plus rehab or improvement costs
- Financing details: Mortgage or loan information, such as the total loan amount, down payment, interest rate, and closing costs
- Income: Rent payments and any other income the property produces
- Expenses: Maintenance costs, including property taxes, insurance, and maintenance
Where to find data
The hard part about this step is getting accurate information. You might think you can get these from the seller… but BEWARE! The seller is motivated to provide you with appealing—not accurate—numbers. For example, they may provide high rental income estimates or neglect to mention certain maintenance expenses.
Part of the investor’s job is ensuring you have the best available information.
Before running your calculations, determine the actual numbers. Ask to see previous years’ tax returns, property tax bills, and maintenance records. Hopefully, the actual data is similar to the seller’s estimates—but don’t be surprised if it’s different.
Not sure where to track down the necessary information? Start here.
- Property details should be available from the seller. Check with your local records office for more comprehensive, detailed information.
- Purchase information includes any upfront maintenance or improvement work that must be completed before the property can meet its income potential. Have the property inspected to ensure that there are no hidden issues or problems.
- Financing details can be provided by your lender or mortgage broker.
- Income details come directly from the seller—but don’t rely on seller estimates. You can also talk to the property management company currently handling the property, if one exists, for this information
- Expenses should also come directly from the seller or property management company. A building inspector can warn you about any major repairs that may come due, such as a new roof or HVAC system.
Step 2: Access the Income and Expenses
Assess the property income
Gross income is the total income generated from the property. Most of a property’s income generally comes from tenant rent, but extra fees like laundry services, storage and parking fees can also increase your income.
When determining how much income you can expect, start by subtracting the income that you likely WON’T see due to vacancy. Most areas have an average vacancy rate of about 5% but find out the real rate in your building instead of estimating. Your property’s rate may be higher or lower.
Assess property expenses
In general, rental property expenses break down into the following items:
- Property taxes
- Maintenance—estimated based on the age and condition of the property
- Management, if you employ a professional property manager
- Landscaping, if you hire a professional landscaping company
- Utilities, assuming any portion of the utilities is paid by the owner
Convert any monthly expenses to their annual costs to find the property’s annual operating cost.
Every property owner will encounter these common expenses—so it’s important to learn how to estimate the cost.
- Repairs: Repairs are difficult to estimate because there are a lot of variables that come into play. When estimating potential repair cost, look at the property itself. Generally, you can assume between 5-15% of the rent, depending on the condition and age of the property. And keep in mind that you may go six months without a single repair and then get hit with a $1,500 water leak. You just never know.
- Capital expenditures: Also known as “CapEx,” this means those expensive big-ticket items that need to be replaced every so often, such as roofs, appliances, and HVAC systems. For each major system, estimate the cost to repair, divided by the remaining lifespan, and set aside that amount every month.
- Property management: Property management companies typically charge a percentage of the rent, along with a fee to rent out a unit. These numbers can change based on your local area, but in my area, property managers charge 10% of the rent and 50% of the first month’s rent when a unit is turned over.
Step 3: Calculate your net operating income (NOI)
Now that we have our total annual income and expenses, we can calculate NOI.
This is your most important real estate investment metric! It determines the total income the property generates after paying all expenses, but NOT including debt service costs or your loan costs.
The basic net operating income formula is:
NOI = Income – expenses
NOI doesn’t give you the whole picture—or even enough information to make any decisions, though. Instead, it is the basis for calculating most of the other important metrics in your real estate analysis, including…
Step 4: Find your return on investment (ROI)
Now you have all the expenses of the property accounted for, and calculated your net operating income. It’s time to include other factors into the mix and find your total return on investment!
There are several other key financial considerations in your return on investment analysis:
- Tax consequences: You may gain or lose money to taxes.
- Property appreciation: Because the real estate market is volatile, you may not be able to predict this, but 2% is a good yearly estimate.
- Equity accrued: Don’t forget, your tenants’ rent pays off the property each month, earning you equity!
- Debt servicing costs: Including your mortgage and any other loan payments.
To learn more about debt and find a mortgage that fits your investment needs, visit our partners at AQRE Lending.
Total ROI considers all these factors affecting your bottom line. Calculate it as follows, where “total return” contains all of the considerations above.
Total ROI = Total return / Invested capital (ie: the money you put into the investment property)
Bonus tip: read our recent article to learn how to lower your property taxes this year!
It’s that simple!
Now that you know the basics, find some investment properties on the AQRE Home platform to practice running the numbers! The more you do it, the faster you’ll be able to spot a good deal.
Sadly, you’ll never be able to fully predict the future—but with accurate numbers, this is as close as you are going to get!