Before you can invest in real estate, your purchase needs to be evaluated just like you would evaluate any other potential investment you were thinking about adding to your portfolio. Conducting an investment property analysis is a way to make sense of that evaluation and weigh the decision of whether a particular property is worth pursuing. We’ll show you what you need to know to conduct an investment property analysis, from start to finish.
How to perform an investment property analysis: First steps for success
When most people think about doing a real estate investment analysis, they assume the process will be mostly about analyzing metrics. While that’s part of it, that’s not the only step needed. Before you can crunch the numbers, take the time to gather some information about the property itself as well as the surrounding area. Here’s how to get the information you need.
Evaluate the property’s rental potential
First, evaluate the property’s rental potential. You’ll want to look at a variety of factors, including:
- Location: The area in which the property is located can directly impact its property value and performance as a rental property, so consider the location carefully before you make a purchase. Be sure to tour the area and take the time to find data about how property and rental values have changed over the years.
- Rental strategy: Next, you’ll want to consider your rental strategy. Do you intend to rent to long-term tenants or short-term visitors? Look at what type of offerings are typically available in your area to get a sense of the competition you’ll face with a particular rental strategy.
- Target tenants: Finally, based on your location data and rental strategy, try to decide who your target tenants for the property will be. If you do decide to pursue the property, there are a number of marketing strategies you can use to find a tenant for the property. Your goal should be to choose the strategy that will appeal most to your target tenants.
Perform a comparative market analysis (CMA)
After you’ve gathered that information, your next step is to perform a comparative market analysis on the property. As the name suggests, a comparative market analysis looks at other, similar properties in the area in order to determine the fair market value of the property. In this case, you’ll look at recently sold comparable property (comps) to come up with a potential purchase price for your offer.
Additionally, doing a CMA will give you a fair estimate of the property value to use when analyzing metrics such as cap rate.
Finding the right investment property data
Finally, look into finding the right investment property data. In the world of commercial real estate, it’s common for a seller to provide the buyer with a pro forma, which includes information about factors like the amount of rental income the property generates from monthly rent. While it’s not standard practice for residential real estate, you can always ask the seller for similar figures and utility information.
Remember that any figures you receive from the seller are likely to be shown in their best light, so do your own due diligence when looking up figures for a property. You can find a lot of data relating to rental income and operating expenses in public property records or your local MLS.
How to perform a real estate property analysis: Analyzing metrics
Once you have all the data, look at the metrics, which will give you a better idea of whether a rental property will ultimately be a profitable investment. Here are a few real estate metrics you can use the next time you need to do an investment analysis.
Net operating income (NOI)
When it comes to analysing metrics, your first step should be to find the net operating income for the property. NOI is a measure of the income the property will generate after accounting for operating expenses. While NOI is not enough to get a full picture of the profitability of a property, it does form the basis of many other equations you’ll use in your analysis.
The formula for net operating income is as follows:
Rental income + other income – operating expense
While the bulk of your income will likely come from tenant rent, be sure to account for any additional sources of income, such as parking revenue or income from laundry facilities. On the other hand, maintenance, utilities, and all of the other usual suspects should get included in the operating expenses portion of this equation. However, your mortgage payment should not. Net operating income doesn’t account for debt service.
After you know your net operating income, calculate your cash-on-cash return. You’ll divide your net operating income by the amount you paid for the property. Your initial investment calculation should include closing costs, the cost of any repairs, and any other initial expenses.
Your cash-on-cash return tells you your return on investment relative to the amount of money you’re investing to acquire it. However, it can also be used to compare multiple properties where different amounts of cash need to be put down upfront.
Capitalization rate (cap rate)
Next, you can find the capitalization rate (also known as the “cap rate”) by dividing your net operating income by the property valuation. A higher cap rate here indicates a greater amount of risk and a higher potential for reward. To that end, there’s no ideal cap rate to aim for. Every investor must decide independently where their comfort level exists.
The cap rate can be used to help you compare multiple properties to see which one is expected to ultimately perform better. Alternatively, if you know the market cap rate for your particular area, you could also use this equation to determine how your investment property stacks up against the competition.
The Millionacres bottom line
Truthfully, no two investors will ever have the exact same method of doing a real estate market analysis. However, this information will give you a good starting point for your next property analysis. Armed with this information, you should be able to make informed choices about whether the property in question makes for a good real estate investment.