Let’s start with quantitative. There are many performance measures an investor can take into consideration while analyzing real estate investments. Make sure to focus on cash flow and returns and not on appreciation.
What Goes In and Out of The Pockets
There are different ways to calculate income. The first formula below, Cash Flow, takes into account the property payments. The second formula, Net Operating Income, does not factor in how the property is paid for. Both are helpful. If the investor knows their payments and interest rates, Cash Flow should be used during the property analysis. If the payment and interest rates are unknown, the latter formula should be used for analyzing real estate investments.
A. Cash Flow
This number tells the monthly or annually profit from the property. Why is this number so important? A negative or break even cash flow indicates an investor should walk away.
1. The first step in the investment property analysis is doing homework and finding out how much the following costs are. Make sure to get approved from a bank before searching for properties and their numbers.
2. Let’s start with investment costs:
- Home Price (cash or down payment)
- Closing costs (usually 6-7% of loan)
- Rehab (if applicable)
3. When calculating monthly expenses, find out and add up these costs:
- Mortgage Payment (principal + interest)
- Property Tax
- Property Management (7-10% of rent, if applicable)
- HOA fees (if applicable)
- Maintenance (4-8% rent)
- Vacancies (4-8% of rent)
- Utilities (if owner is paying any)
4. To determine monthly income:
– See how much rent tenants are currently paying
– If there are no tenants, evaluate the rental income of nearby properties and consult a realtor or property manager about how much income to expect
– Go with the lower end of their estimates for an investment property analysis.
5. Calculate Cash Flow:
Monthly Income – Monthly Expenses = Cash Flow (should be positive)
Tip: Calculate in an additional mortgage payment per year to pay off a 30-year mortgage in 18 years. If buying an Airbnb investment property, don’t forget to include additional costs such as host service fees.
B. Net Operating Income (NOI)
This number tells the income for a property excluding the acquisition costs.
1. Add up income and multiply by 12 months.
Monthly Rent X 12 = Annual Income
2. Add up expenses and multiple by 12 months – again, this excludes the mortgage payment.
Monthly Expenses X 12 months = Annual Expenses
3. Deduct expenses from income to get NOI.
Annual Expenses – Annual Income = NOI
Tip: This measurement is not enough to make a decision. This is useful for analyzing multiple real estate investments at once.
Ok let’s go deeper now. . . .
Returns & Profiting
There are also different ways to analyze returns. The first formula gives the return from the investment property while the other formulas help indicate if the returns are significant or not.
A. Return on Investment
This number gives the annual return on the investment by taking in all factors that affect the bottom line.
1. We know our monthly cash flow.
Monthly Income – Monthly Expenses = Cash Flow
2. We know our mortgage payment (principal + interest). The principal amount of the payment is the monthly equity build, meaning how much has been put in into obtaining the property. Add the cash flow to the monthly equity build.
Cash Flow + Principal Payment
3. Multiply that by 12 months, which gives the annual return (it’s a return because it’s cash in the pockets and a payment closer to owning the property).
(Cash Flow + Principal Payment) X 12 months = Annual Return
4. Divide that by total investment costs.
Annual Return/Investment Cost = ROI
Tip: Cash Flow and ROI are the most important formulas in making the best decision during an investment analysis.
What is a Good Return?
Excellent question! What’s the use of calculating all these numbers if an investor doesn’t know what to aim for? Here are some additional numbers to look at when inferring this.
This number tells the returns of the property independent of the financing. Why is this number important? This is an utter way to understand a property’s returns independent of how the property is financed. In other words, this is the return of a property as if it was already paid off.
Cap Rate = NOI/Property Price
Cap rates are usually 8-12% but the best way to determine if a property has a good cap rate is dependent on the location. Set the average cap rate in an area as the minimum goal.
B. Cash-on-Cash Return (CoC)
This number tells the returns of a property based on the amount of cash put in the investment.
CoC = NOI/Investment Costs
Generally, 10% is considered a good cash on cash return but again, that depends on property type, location, and rental strategy.
The different computations for analyzing a property can get overwhelming but these are the major ones to look at. There are other values that are good to know when comparing an investment properties. They can be helpful in indicating what are the average ranges based on areas since property performance is so dependent on location.
The thing to remember when doing a real estate investment analysis, costs are current but they can change every year. For example, rental rates and expenses will most likely increase every year so don’t expect these calculations to stay constant throughout the investment. Appreciation is another factor when calculating returns. Although it is not guaranteed, an investor can include this in the Total Return to calculate Total ROI.
Finally, there are different tools that provide real estate analytics. Instead of creating spreadsheets, Mashvisor provides a predictive analysis for each property which is based on historical and comparative data. An investor can instantly get a break-down of cash flow, cash on cash return, cap rate, etc. The investment property analysis is based on seasonality trends, how other properties in the area are performing, and neighborhood insights.
That was a lot of information, huh? Ok, let’s quickly go over the qualitative data.
When selecting a market or an area, see if the market is growing. If there’s a lot of construction going on, that means people will move to that area and bring tenants. The job market is another very important factor because tenants go where there are job opportunities. Markets with low unemployment rates are favorable.
Tip: Don’t select a market that is dominated by one job industry. If that industry fails, there is no more job market.
When choosing a neighborhood, make sure the location is on point! Understand what the target tenants are looking for. Depending on tenants, schools, crime rate, amenities, public transportation, noise levels, zoning laws are all things to look into.
Getting an appraisal and inspection are crucial when selecting a property. It’s important to stick the budget that has been set and to know the deal-breakers after inspecting a property.
While all of this criteria should be carefully contemplated, it should also go hand-in-hand with the cash flow and budget. A city center is a great location but if the investor can’t afford it, the investment will not get the returns hoped for. Analyzing real estate investments takes time and patience but the benefits are securing a good investment and learning about different markets and properties in the meantime.
Find and analyze investment properties on Mashvisor.