How to Analyze the Financials of a Real Estate Investment
Wondering how to analyze a real estate investment? Today’s guest post by Scott Pastel offers guidance.
Scott is VP of Property Management and Real Estate at Marshall Reddick. Marshall Reddick is a nationwide real estate firm that provides real estate agents, property management, investments, education, and consulting.
Analyzing a real estate investment
by Scott Pastel
One thing I have learned in my 8 years in real estate is that everyone seems to have a different notion for what a property analysis should look like. I’ve also found that there are a lot of people in this industry who provide financial pro formas that lack a lot of the necessary information to calculate a realistic rate of return. The fact of the matter is, even if all of the pertinent information is provided to you, you must make sure that conservative numbers are used for variables like rent, maintenance and vacancy. When it comes to real estate investment, no one can guarantee these variables. Make sure the numbers you are provided are NOT the “best case scenario,” but instead, the worst case scenario.
When you are analyzing investment properties for purchase, it is critical that you know how to read a financial evaluation intelligently. This is not something taught in school, yet so important to your financial future. A wise man once said to me, “Trust, but verify.”
I have stared at thousands of financial evaluators for residential investment property over the years, and it seems like no one can agree on what should be included in the calculations. Here is my firm stance on what should be included and how it should be calculated. It’s very important that you read and understand the following:
Make sure you are comparing “apples to apples”
All too often I see first time investors compare and contrast properties without using the same measurements to compare them. You must make sure you are on a level playing field. If you are constantly using different measurements for your pro formas, then you are not comparing apples to apples. For example, make sure you are using the same down payment and interest rate when comparing the returns on two different properties.
Know your total out of pocket cost
Knowing your total out of pocket cost to acquire the property is essential before purchasing. Without it, you cannot calculate your anticipated returns, i.e. how much money you stand to make. This includes down payment, closing costs and any estimated repair costs.
Figure out all your expenses, and don’t leave any out!
In your financial analysis you must list the principal and interest (if you are using financing). Also include property taxes, insurance, property management fees, anticipated maintenance costs, estimated vacancy factor, and any HOA fees. Underneath all of those expenses, create a line to tally everything up and call it “total expenses.”
When it comes to maintenance and vacancy, it’s not IF but WHEN
I’m always amazed to see how many people do not add those expenses into calculating their net cash flow. The actual amount for each expense varies, but to play it safe, I recommend the following. Use 4%-8% of your rental income for vacancy and 4%-8% for maintenance. Those numbers will vary depending on age, condition, and location of property. If you purchase the right properties in the right areas, these should be pretty conservative numbers to use. If you’re sure what number to use, just pick 8%. It’s always better to make money from a miscalculation than to lose money from one.
Now comes the fun part, conducting an analysis of your annual return, or “cash-on-cash” return
This is achieved by dividing the annual net cash flow by the total out of pocket cost to secure the property. If your net (after all cost) cash flow is $200 per month or $2,400 for the year, and your total out of pocket cost was $24,000, your annual return is 10%. Calculating your Total R.O.I. (Return on Investment) is a more comprehensive formula that takes into account principal pay down, tax write offs, depreciation, and appreciation. For a comparative analysis, the brief formula described above works best.
One of the biggest mistakes you can make is overestimating the rent
If you are given a rent range, always take the low-end. You will be pleasantly surprised if it rents for more. Trust me when I say, it is no fun the other way around.
It’s not only about the numbers in real estate!
Make sure you get interior and exterior photos of the property from your real estate agent so you can find out more about it. You need to know whether or not it’s rented, what the condition is like (home inspection), and other information that numbers can’t always tell you. Make sure you have the specs like amount of bedrooms and bathrooms, square footage, and year built. All of these factors will affect your bottom line.