How to Analyze a Real Estate Deal
When getting into real estate investing, it’s imperative that you understand how to compare properties, markets and various deal metrics. Whether you’re trying to decide between investing in multifamily or office, or Dallas or Denver — a good place to start is with the team at Realty Capital Analytics.
Different-sized properties require more or less analysis, but consider this a primer to analyzing a deal, from two-unit duplexes to 500-unit complexes. This approach even works for single-family rentals, but keep in mind that the market value for single-family homes is determined differently than for larger commercial properties.
Determining the Value of a Real Estate Investment
As mentioned, different properties are valued differently. Assessing a quadruplex the same way one might evaluate a single-family home leads to a wildly skewed value. Here’s what you need to know:
Single-Family Homes
Market “comps” determine the value of single-family homes, investment or not. These comps—or “comparables”—are nearby properties with similar characteristics. They share variables like floorplan, lot size, number of bedrooms and bathrooms, garage size, and amenities. A single-family investment home generally rises in value if a similar home is also rising in value—and vice versa.
Multi-Unit and Commercial Properties
Larger investment properties—those with at least two units, and especially those with more than four—are priced and valued differently. The value equates directly to how much income or profit the property produces. It’s possible that an apartment building in a neighborhood where home prices are dropping could, in fact, 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.
There are several factors to consider, but cash flow and appreciation are the two most important variables. Cash flow is simply the money left after all the bills have been paid, and appreciation is the equity gained as the property value increases.
Gathering the Details
Good financial analysis involves inputting a bunch of information into a financial model and using its calculations to determine whether the investment is good or bad—and right for you and your investment objectives.
Property details: Number of units, square footage, utility metering design, etc.
Purchase information: Total purchase expenses—or purchase price plus rehab or improvement costs
Financing details: Mortgage or loan information, such as the total loan amount, down payment, interest rate, term, amortization vs. interest-only, pre-payment penalties, and closing costs
Income: Rent payments and any other income the property produces
Expenses: Maintenance costs, including property taxes, insurance, and maintenance
Property Taxes: The ad valorem tax based on the value of the property
Real Estate Market Data: Local economic factors influencing real estate markets, comps, and transaction volume
Capital Market Data: The cost of capital across, and how investors are pricing risk and cash flow amongst different asset classes
Pro-Forma vs. Actual Data
Getting good data from your model requires reliable, accurate information – the best model in the world with bad assumptions is useless.
“Pro-forma”—or estimated—data from the seller merely kicks off the discussion. Before closing, 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 pro-forma data—but don’t be surprised if it’s different.
Remember: It’s in the seller’s best interest to provide appealing—not necessarily 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 doing thorough due diligence and ensuring you have the best available information.
Check for potential surprises, too. For example, when was the last time the property was assessed for taxes? If it was a while ago, and values have increased significantly, it’s possible that the property will soon be reassessed and taxes will increase. Even small changes to the income and expense numbers can mean big changes in your bottom line.
Elements of a Real Estate Investment Analysis
Let’s discuss each component of a basic real estate investment analysis:
Calculating Net Operating Income (NOI)
One of the cornerstone metrics of your financial analysis is “net operating income” (NOI). This determines the total income the property generates after all expenses, not including debt service costs—or your loan costs.
Investopedia defines NOI as a calculation used to analyze the profitability of income-generating real estate investments. NOI equals all revenue from the property, minus all reasonably necessary operating expenses. NOI is a before-tax figure, appearing on a property’s income and cash flow statement, that excludes principal and interest payments on loans, capital expenditures, depreciation, and amortization.
In basic mathematical terms, NOI equals the total income of the property minus the total expenses of the property:
NOI = Income – Expenses
Typically, NOI is calculated monthly using income and expense data, which can be easily converted to annual data.
Assessing Property Income
Gross income is the total income generated from the property, including tenant rent and other income from things like laundry facilities and parking fees.
Most of a property’s income generally derives from tenant rent—making it extra important to account for lease term and unit vacancy. Most areas have an average vacancy rate, although your property’s specific vacancy rate may be higher or lower, which you’ll want to factor into your analysis.
Here are questions to ask if the vacancy rate doesn’t correlate with the average local vacancy:
Is the data pro-forma or actual? If it’s actual, what is the current management doing to keep the building filled?
Is rent lower than market rents?
When do current leases expire, and are there any month-to-month leases?
You’ll need to determine what you think is a reasonable vacancy rate going forward—I always recommend erring on the conservative side when underwriting a deal for a potential investment.
Assessing Expenses
Now let’s talk about how to calculate total expenses for a property. In general, expenses break down into the following items:
Property taxes
Insurance
Maintenance—estimated based on the age and condition of property
Management, if there is a professional property manager employed
Leasing Commissions
Marketing & Advertising
Legal
Landscaping & Snow Removal
Janitorial
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.
Common Expenses
In addition, every property owner will encounter these common expenses—so it’s important to learn how to estimate their cost.
Repairs: Repairs are difficult to estimate because there are a lot of variables that come into play. When estimating potential repair costs, look at the property itself, its age, and historical financials.
Capital expenditures: Also known as “CapEx,” this means those expensive big-ticket items that need to be replaced every so often, such as roofs, parking lots, and HVAC systems, that extend the useful life of the asset. 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 and proper due diligence needs to be done by evaluating existing, and other potential property management companies.
Calculating NOI
Now that we have our total annual income and expenses, we can calculate NOI using the previously mentioned formula:
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 important metrics in our analysis.
Common Real Estate Performance Metrics
In the last section, we learned that NOI was the total income the property produced. But you might have been wondering, “Why doesn’t NOI include the expense cost of the loan, since that will ultimately affect your bottom line?”
Great question. Let’s discuss cash flow.
Cash Flow
Cash flow is the money left over after all the bills have been paid. However, this simple definition gets a lot of people in trouble. You see, technically, cash flow is:
Income – Expenses = Cash Flow
However, unlike NOI, cash flow also includes your debt service under “expense.” We don’t include debt service in the NOI calculation because NOI dictates how much income the property produces—independent of the owner’s financing.
The monthly or annual debt service amount is specific to your financing plan. If we included debt service in the NOI, then NOI would only be meaningful for that specific loan. Different buyers have different financing, so it’s important to have a property-specific income metric.
As might now be obvious, cash flow is your total annual profit. The higher your loan payments, the smaller your cash flow. If you pay cash for a property, your cash flow is the NOI exactly, because that’s the property’s maximum cash flow.
Cash-on-Cash Return
This is one of the most important return on investment metrics in real estate investing. From the name (cash-on-cash), you can conclude that this metric measures the cash income earned on the cash invested in a property. Sometimes referred to as the cash yield, this metric is normally used to measure the performance of commercial real estate investments, but can also be used in residential real estate investments such as rental properties.
When we talk about cash-on-cash return, say, versus Return on Investment (ROI), the main difference that comes to mind should be the debt factor. When you take out a mortgage to buy an investment property, the actual cash return on the investment differs from the standard return on investment (ROI). Cash-on-cash return only measures the return on the actual cash invested, providing you with a more accurate analysis of your investment’s performance.
Return on Investment (ROI)
Return on investment, or ROI, is a profitability ratio. Therefore, it measures how much money or profit is made on an investment as a percentage of the cost of the investment. When we say ROI, we’re taking into account the entire cost of this investment property. ROI shows real estate investors how effectively and efficiently investment dollars are being used to generate profits. It also determines how well an investment is performing.
Cash-on-Cash Return vs ROI
The main difference between these two metrics is, obviously, the calculations involved in finding each metric.
Cash-on-Cash Return = Annual Pre-Tax Cash Flow / Actual Cash Invested
The basic formula is very simple. You divide the net cash flow generated from the investment property for the year by the cash you actually invested in that property. Remember that the annual pre-tax cash flow is found by subtracting your annual mortgage payment from your net operating income (NOI).
ROI = Net Profit / Total Cost
This formula has a more general sense because ROI is used as a measure of profit in many other types of investment, unlike the cash-on-cash return, which is typically only used in the case of real estate investing. To calculate the gain on an investment through ROI, we take the net profit (net gain) on the investment and divide it by the original (total) cost of that investment.
Capitalization Rate (or Cap Rate)
Just like NOI is completely independent of financing costs, the cap rate is a neutral figure independent of the buyer or their financing. It’s calculated as follows:
Cap Rate = NOI / Property Price
The cap rate may be the single most important number in your real estate investment analysis. The cap rate is independent of the buyer and financing, making this calculation the most pure indicator of a property’s potential return.
A “good” cap rate depends on where you’re buying, the asset type, the market, property condition, the creditworthiness of the tenant(s), vacancy, and the amount of lease term remaining. Most areas, however, see maximum cap rates between 5-10%.
Just like single-family houses, where prices are determined by comparable houses nearby, larger investment properties are valued based on the cap rate of comparable investment properties.
The Internal Rate of Return (IRR)
One of the most commonly accepted ways to gauge the profitability of a real estate investment is by calculating its Internal Rate of Return (IRR). This is a metric that tells you the average annual return that you have either realized, or can expect to realize, from a real estate investment over time, expressed as a percentage.
At its core, Investopedia defines the Internal Rate of Return, or IRR, as a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis. The mathematical formula for IRR therefore involves finding the discount rate, or interest rate, that sets all the project’s cash flows to an NPV of zero.
A project with a positive IRR means you have earned a return on your investment. A negative IRR implies you are losing money on your investment.
The basic idea behind the IRR is to combine a measure of both profit and time into a single metric.
The concept of profit is relatively straightforward: how much cash an investment generates relative to the amount you invested.
The time value of money is a somewhat more complex concept: Inflation affects the value of money over time, meaning a dollar today is worth more than a dollar five years from now.
Similarly, every investment has a trade-off, or opportunity cost. If you choose to invest in project A, it may mean that you are forgoing the opportunity to invest in project B. Or, if you receive a dollar today, you could invest that dollar and earn a return; but if you receive that dollar in the future instead of immediately, you are, in effect, missing out on potential return.
Over the life of a real estate investment, which can last for several years, you will receive a series of cash flow payments from tenants, as well as a larger lump sum once a property is sold. Occasionally there may also be a refinancing or some other event that creates additional cash proceeds. Because these cash flows occur over many months or years, their relative value isn’t equal. As discussed above, a dollar today is worth more than a dollar five years from now.
Using the IRR will allow you to derive an apples-to-apples comparison across investment opportunities by appropriately weighting cash flows that occur at different times.
It is important to note that for most real estate investments, the initial IRR is only an estimate based on a number of assumptions. However, it is still a valuable tool for measuring a project’s potential annualized return. Once the investment is sold, the actual final IRR can then be calculated.
Wrapping It Up
In conclusion, bear in mind that we have mainly focused on the first year of property ownership, and this is a very basic high-level overview of a real estate investment analysis. In subsequent years, accrued annual equity increases, expenses rise with inflation, rental rates increase or decrease, the market fluctuates, and tax situations change. And we aren’t even beginning to cover the complexities in larger syndicated deals, equity distributions, etc.
You can’t predict the future, but a solid and thorough approach to analyzing an investment opportunity will you help objectively and confidently determine if a property is right for you and your goals.