The numbers come out, the charts pile on and it's a S-L-O-W death by calculator boredom, with the occasional painful flashback to 9th grade algebra. Well hold on to your socks because I have good news for you...not only is property analysis not nearly as complicated as some may think but it can actually be kind of fun. Yep, I said it 'fun'.
You don't need to be an honors calculus wiz or hold a PhD to analyze properties...what you do need is a basic understanding of simple math, an understanding of the investment metrics that matter and a simple calculator. At some point whether you are looking to invest in a single-family home rental, an apartment building or any other type of investment property you will need to know the basics of analyzing a property.
Phases of Property Analysis
When running the numbers on any investment property there should be, in a very simple way to put it, three phases of analysis, as far as numbers go:
The numbers of the sales comps or area cap rate
The numbers on the rental comps
The numbers on the property itself i.e. income, expenses, etc.
Aside from the numbers, you should also look at, the neighborhood, determine the area's unemployment rate and whether the median local income can support at least 2 to 3 times the average rent amount of the property you are seeking to purchase.
Supporting neighborhood income is important especially if you are considering a 'value add' strategy which you plan on commanding higher rents - if the local income can't support it, no amount of upgrades or updates you undertake is going to drive your rents upward. While you're at it take a look at your competition's rates, quality and amenities and see how they compare to your property.
Water Cooler Talk
I'll let you in on a little secret...there is one question that is the most important, the most crucial and the most overlooked question of all, overlooked by even the most seasoned investors...wait for it...okay I'm sorry but here it is:
You need to ask yourself "Do you even want the property regardless of how good the numbers are?" - Do you want it? It's such a simple question that most of us overlook its importance. You will have to deal with the property long after the closing, manage it and deal with any issues that arise later down the road, the good and the bad...is it worth it to you? and is it worth your time?
Phase 1: Sales Comps and Cap Rates
Well, I'm glad you decided its worth it because truth be told Real Estate is an investment like no other with benefits that can supersede all other investments when done correctly...now back to the numbers.
When running the numbers on an investment property you should be looking for cash-flow, as in positive cash-flow and for equity which is either already built in through the purchase or through a 'value add' opportunity (more on this in another article).
If the property is between 1- 4 units you should look at the area comps to see what the property is worth, aiming to get as close to 20% in equity as possible or greater on the purchase. Remember however, that equity is very rarely ever just sitting there for the taking, but one can get there through a value add after purchase i.e. adding an extra bedroom, garage, updates, etc. If the property is 5+ units look at the area cap rate and ensure the price falls in line with it.
Phase 2: The Rent Comps
Rent comparable sales or 'comps' are important in order to determine what you can reasonably charge for rent. Whereas the MLS is the preferred method for determining comps when selling a property, when it comes to rentals Zillow, Craigslist and similar opensource sites are the apex for rental comps. This is so purely because a large part of the rental market is done without using realtors, which in turn makes the MLS obsolete as far as rent comps are concerned, of course you should still check the MLS in addition to open sources, if you have access, but don't place too much weight on it.
Phase 3: Income and Expenses
To start off on the right foot you should always ask for a property's financials, its history and disclosures when possible. However, for properties of 1-4 units financial records may not always be reasonably possible and they will typically be non-existent. For properties of 5+ units requesting the profit and loss (P&L) statements, the rent roll and the 'T12-24' (trailing 12-24 months of finances) should be standard practice since these types of properties depend on their net operating income to determine the properties' value and worth.
"Do you want it? It's such a simple question that most of us overlook its importance."
Income: You need to know what the expected income of the property will be...after all that is the point! To do this, you must look at your market rent comps and the property financial performance record (if available). What is the total income from rents? Are there other income streams present i.e. washing machines, storage fees, etc.? Are there possible income streams that the current owner is not aware of?
Taxes: When running the numbers on the actual income and expenses you need to make sure to account for the increased taxes that are likely to occur after the purchase. A call to the local tax assessor for that specific property or visiting the county's website can help you determine the current and post-purchase taxes. If taxes are homesteaded, as is the case in many Single-Family Homes and you are not occupying the property, you need to account for the change into non-homestead taxes which is typically higher.
Insurance: Insurance is a major expense and you should initially call local insurance carriers for coverage quotes. After a few properties you will be able to reasonably estimate the cost of insurance premiums without having to call an insurance provider until you get serious about a property or more in depth in your analysis.
CapEx and Maintenance: Although capital expenses and maintenance may seem to be one in the same, they are actually two separate expenses and should be calculated as such. Maintenance accounts for the every day cost of repairs for items such as holes in the wall, broken doors, etc. whereas CapEx accounts for big ticket 'every once in awhile' items such as a new roof, new windows, etc. Accounting for the correct CapEx and maintenance budget can be challenging, especially considering that a big determinant of what should be allotted largely hinges on the type of property and 'property class' - A, B, C or D/war-zone. As a general rule of thumb however you should account between 5-10% of the gross rents for both but keep in mind that is very broad and should be adjusted up or down depending on the property class, property type and property history.
Vacancy: Another expense that must be accounted for but often gets overlooked is vacancy. At some point in your rental's history there WILL BE a vacancy either a physical vacancy from turn-over and repairs or an economic vacancy from non-payment and evictions, and you must account for it. There are many factors that affect vacancy a few of which include your property class, quality and neighborhood. Generally speaking however and as a general (very general) rule of thumb you should account for 2-5% vacancy on properties of 1-4 units and at least 5-8% vacancy on properties of 5+ units, if you do not have access to the property's rental history. If you do have access to the property's rental history simply take the maximum scheduled gross rent vs. the actual received gross rent for the year to find the property's true vacancy.
Other expenses to factor in include HOA dues, waste collection, snow and lawn maintenance, utilities, advertising, legal expenses and property management.
Putting it All Together
You did your homework and got all the right numbers but, what does all this madness mean? Well let's put the numbers into context by using them to determine some basic investment metrics such as the NOI, Cash-flow and ROI.
NOI: The Net Operating Income is calculated by taking your total property income received minus all expenses except for the principal and interest. Why is NOI important? Well, the NOI is not as important in 1-4 units as it is for properties of 5+ units. In properties of 5+ units the NOI will directly dictate what the property is worth. You simply take your NOI and divide it by the market cap rate and you will arrive at the value of your property.
Cash-Flow: Cash-flow, what is it? Simply put, cash-flow is the income you will actually get to keep in your pocket after all expenses. The cash-flow that your property yields is determined by taking your total property income minus all expenses.
ROI: How do you gauge and compare your Real Estate investment vs. all other investments out there? Let me introduce you to ROI. Return On Investment is typically represented as a percentage which you can use to compare your investment property to all other types of investments i.e savings, stocks, other properties, etc. ROI is determined by taking your yearly cash-flow and dividing it by your total out-of-pocket cash outlay during the purchase to make the property 'rent-ready' i.e. down payment, closing costs, repairs, etc.
We've covered the three phases on an investment property analysis...now in addition to those you should consider conducting three separate analyses for each property that you deem purchase worthy.
An analysis with the numbers the Seller/Broker has presented you with.
An analysis accounting for your standard minimums and maximums i.e. vacancy, CapEx, etc.
An analysis accounting for the projected value add potential i.e. increasing rents to market value, etc.
Why three separate analyses? You want to analyze the numbers the Seller gives you as they stand to see how the property is performing as per the Seller - this will usually be the best case scenario since they are the Seller's numbers and if even the best case scenario here looks grim, you can decide whether or not you want to proceed. Then you want to run a second analysis by adjusting and including your criteria minimums and maximums, this will give you a much better idea of the best and worst case scenario of property's 'true' performance under your management and is much more accurate then merely relying on the numbers the Seller - the person that is trying to unload the property - gives you. Lastly, you should run an analysis with your value add projections to see what the property could become - a word of caution here, you should not be basing your decision on purely 'potential' and 'what it could be' - doing so is ultimately risky. These 3 separate analyses should give you enough depth and perspective to allow you to make a well educated investment decision.
These are just a few bullet points of the most important metrics that you should consider prior to pulling the trigger on that investment property you've had your eye on. There are certainly many more metrics you should eventually consider but these few will set you in the right direction. Initially it may take a bit to learn how to analyze a property however, after you get it down it shouldn't take you more than 10-15 mins per property and guess what? To make your life easier, G3 has an awesome property analyzer tool to help you; you can download it here for free! (You're welcome). As you go eventually you will be able to just tell if a property is under-rented or over priced etc. Remember this however: it is typically easy to find a property that cash-flows and has a favorable ROI; what is a bit more challenging is finding that along with equity or value add potential - an investment should have upside as well as cash-flow.
About Ricardo Reis
Ricardo is a member of G3 Management & Investments and a real estate professional. He has been a successful property manager and real estate investor for over 10 years.