Introduction to Real Estate Investment Analysis
Before you go into real estate investing, you need to understand how the market works. Failure to understand and master the industry is a recipe for disaster since you will most likely invest in the wrong properties and at the wrong location. Comparing properties and their current value is an essential piece of the jigsaw puzzle. Get it right, and you will have a portfolio of valuable assets. Get it wrong, and you will have a set of good and bad assets.
Before you even decide to buy a property, it pays to conduct investment analysis to enable you to determine whether the asset is worth the value the seller is looking to sell for. Different assets command different values and so, therefore, require less or more analysis. The analysis a single unit home will require is not the same one a multi unit property will require. Regardless of their sizes, you still need to ascertain their true value before you go ahead to pay for it.
How to Determine the Value of your Real Estate investment
The first step to a successful real estate investment is what we call portfolio or investment analysis. This process is all about evaluating the asset you intend to buy. There are different types of residential properties, and the approach to evaluating these properties depends on their size and certain intrinsic features.
For the purpose of this article, we will stick to residential properties, not commercial properties. Here are two common property types you may likely invest in.
Single-family homes
Single family homes are simply properties designed for nuclear families or single families consisting of couples and their kids. Single unit homes may have different sizes and shapes, but they basically have the same architectural profile. Common features with these types of properties include a certain number of bathrooms and bedrooms, floorplans, and other necessary amenities in the house or outside the home. One common theme with Single family homes is that they rise in value if other single family homes in the area are equally rising in value.
Also, just like with other real estate assets, the value of single family homes is influenced by their size and, more importantly, where they are located. Homes with more bedrooms also command a higher price.
Multi-unit Homes
Then we have multi unit homes. These types of homes are several single family homes designed in a single structure, and they come in different shapes and sizes. There are four, six, eight unit buildings and above. These types of multi unit homes are valued based on several factors, including the potential rental income they will generate.
Also, multi unit homes are houses in apartment buildings often of 2 or more storeys. In terms of their value, multi-units do not react to the market exactly the same way that single unit homes do. While a drop in home prices in a location may also lead to a drop in the value of single unit homes in that location, multi unit homes may react to the market situation differently. In some cases, a drop in price in that location may lead to an increase in the price of a multi unit property.
As you can see from the explanation given above, you can’t simply compare the value of similar properties at face value because different factors influence their prices. This is why there is a need to conduct a comprehensive real estate investment analysis on any property you wish to buy independent of any other property. Two major factors that influence price are
- Cash flow
- Value appreciation
While value appreciation is possible to predict, it is not an easy thing to do due to several mutually exclusive factors that affect value. However, cash flow is possible to predict, that is why portfolio managers prefer to use it as an evaluation metric.
Information you need for your Real Estate investment analysis
When it comes to analyzing real estate investment, you need as much data as you can find; not just any data but accurate data. Inputting data into your financial model will help you determine the feasibility of the investment and whether going ahead will be in your own best interest.
Here are some of the variables you need to perform sound investment analysis.
- Number of units in the property
- Property square foot
- Utility metering design
- Total purchase and rehabilitation expenses
- Potential rental income
- Mortgage value
- General expenses (maintenance cost, Insurance, etc.).
Actual Value vs. Proforma Value
How you generate your data is very important, and so is the model you use. If your data is inaccurate, your analysis will be dead wrong, and the consequence will be a financial loss. This is why as a buyer, it is unwise to believe the information provided by the seller about a property you are looking to buy. Sellers will never sell themselves short, so they will always paint their property in a good light. So the responsibility lies with you to do your own due diligence before you sign off on the purchase. What you should find out is the actual value of the property.
Pro-forma Value
The Proforma Value is an estimated value put forward by the seller. This value is put forward to set the negotiation ball rolling. Actual value and Proforma Value are not the same things, and as the negotiation winds down to a close, the actual value of the property will be arrived at by both parties. One way to be sure that the value is what the seller claims is to demand the tax returns, maintenance records, and other bills.
Where to find data for your investment analysis
There are so many places you can get data for a property. Here are some data sources to bear in mind.
Local records: The local records office in the area will have some information about the house in question. You can get some information about the property by simply checking the local records.
Receipts: The receipts of sale is one document you will find valuable information. Also, receipts for maintenance and home improvement works will give you a fair idea of the value. To be sure that the improvement and maintenance projects were carried out, make it your responsibility to inspect the property in person.
Mortgage information: If the property was purchased or refinanced using a mortgage, the mortgage contract agreement between the lender and the owner would show the cost of the house at the time of purchase. Although the value may have increased or decreased after then, however, the mortgage agreement will provide you with valuable information about the cost of the house.
General expenses: Valuable properties cost more money to repair or improve. If there are HVAC systems on the property that have been repaired or installed, demand to see the receipts. Demand receipt for installed roofs and any other repair exercises carried out on the property.
Elements of Real Estate Investment Analysis
To give you a clear idea of what an Analytical chart should look like, here is a sample.
Example
No 23, Pennsylvania Avenue
| Units | 8 Housing Units (7 rented and 1 vacant) in need of repairs that will cost $10,000 |
| Price | $400,000 |
| Cap Rate | 9% |
| Gross Income | $54,000 |
| Other Income | $2,400 from laundry |
| Vacancy Rate | 12% |
| Taxes | $4,000 |
| Insurance | $600 |
| Maintenance | $3,000 |
| Utilities | $$2000 |
| Advertising | $300 |
| Net Operating income | $37,169 |
Calculating your net operating Income
One of the main goals of analyzing the value of a property is to enable you to ascertain the net operating income the asset can generate. The NOI, as it is often called, is simply what is left after the deduction of all expenses. In mathematical terms, NOI is ascertained using this Formula
Income – Expenses = NOI
A property’s NOI is calculated by relying on the monthly income and expenses information over a one year period.
Assessing the potential Income of an asset
The gross income of a property is the combined total income it can generate in a monthly or yearly period. This income is sourced from the rents paid by tenants and other fees like parking fees, laundry services, and the likes. In the example we gave above, you will notice that the building has 8 units. Let’s say the rent ranges between $525 – $650 a month, and the total monthly rent for all occupied units is $4,500 and an extra yearly income from the laundry at $2,400 annually, the total income for the year will be $54,000.
Now, one factor that will affect income is the vacancy rate. Occupied units generate income, while unoccupied units do not. So to ascertain the vacancy rate, you want to find out about
- The expiration of the current lease
- The current rent paid by the tenants (whether it is higher or lower than the rate for other houses in the location)
- If the value is the actual or Proforma value
To be on the safe side, you may want to use a conservative figure.
Assessing the potential expenses of a property
The next thing is to ascertain just how much it will cost you to keep the property running. Common expenses include
- Insurance
- Utility bills
- Property tax
- Maintenance
- Property management fees (optional)
- Landscaping (If there is one)
- Advertising
To arrive at your operating expenses, multiply all expenses by 12 months to arrive at the total annual cost.
Calculating NOI
With your total income and expenses already ascertained, now is the time to calculate your Net operating income (NOI) using the formula.
$49,920 (income) – $12,751 (expenses) = $37,169 (NOI)
The NOI is an important piece of information, but it does not tell you all you need to know. Rather it provides you with the foundation you need to calculate other important data. Chief among them is cash flow.
Cash Flow
In real estate, cash flow is defined as the amount of money left after all bills and expenses have been paid. It is calculated using this Formula
Income – Expenses = Cash Flow
However, relying on this formula alone to find your cash flow is unreliable because of the numerous expenses involved. Moreover, certain expenses cannot be planned for like a broken pipe. This is why cash flow is a touchy subject and should not be treated with kid gloves.
Also, note that under NOI, debt servicing is not included under expenses, but for cash flow computation, you have to include them. However, it is NOI that will determine how much income the property can generate. Also, the NOI should determine how much you pay for the property, not the cash flow.
Return on Investment
Besides the cash flow, it is also important to note that the return on investment (ROI) is another major index that should guide your investment decisions. Your return on investment is the amount your investment generates relative to the cost of your investment. ROI is defined as thus
ROI = Cash Flow / Investment
To ascertain an ROI that is worth your investment, here are certain things to consider.
- Accounts with high interest savings often attract ROIs of 2%-5%
- An average deposit certificate has an ROI of 5%
- The average Stock Market ROI ranges between 8%-10%
These and more are some of the average data you should know about ROI.
Conclusion
The subject of Real Estate investment analysis is very wide and far-reaching and cannot be exhausted in a single article. However, it provides users with valuable data to help them make important investment decisions.