For anyone looking to become financially independent, real estate investing remains one of the most surefire ways to achieve it. Whether you’re looking to get into fix n’ flips, rentals, or buy and holds, the options and potential for success are nearly endless. But getting started is always the hardest part, and like every beginner, you may be afraid of making a few mistakes. How can you tell whether certain property is a good investment? How do you compare two or more homes to find the one with the highest returns?
One of the first things that every successful investor learns is how to analyze a real estate investment. This is how you get to the heart of whether an investment is a good one or not. It involves a very though process, summarized in five easy steps that we’ve outlined below.
Analyze the LocationAnalyze the Location
Location, location, location. It’s the old cliché we’ve all heard before and the first thing you should start with when evaluating a property. Any home’s location will have a major impact on property prices, appreciation rates, how much you can charge in rent, and the type of tenants you’ll attract. Failure to consider location is one of the prime reasons why many new investors run into trouble. A home could have nearly everything else going for it, but almost nothing will rectify that if it’s in a bad location.
So, how can you assess whether a home is in a good location? Start by pulling all the numbers you can on the area and see what they tell you. This includes:
- Population growth
- Job market growth
- Economic growth
- School ratings
- Walkability and access to public transportation
- Safety and crime rates
- Taxes and local laws
With all of this data in hand, you can evaluate the strengths and weaknesses of each location. Your chosen investment should be in an area with strong price growth and easy access to public transportation. These are the areas that command the highest rental prices and where you should see your profits grow the most over time.
Gather All the Necessary Property DataGather All the Necessary Property Data
Every property comes with a heap of data that can help you assess its market value and what kind of ROI you can expect. The only difficult part is finding all this information. If a crucial piece of information is missing or inaccurate, your ROI predictions could get thrown off. This is how you can end up with a negative carry investment. To avoid this and ensure you get the best possible ROI, your property data list must be thorough and up to date. You may have to do some digging to get these numbers, but the effort is well worth it. Also, depending on the type of property you’re buying, the necessary property data may vary. But at a minimum, you’ll need the following:
- Property characteristics
- Listing price
- Utility bills
- Maintenance fees/common charges
- Capital expenditures
- Vacancy rate
- Rental rate
- Down payment
- Interest rate
- Mortgage term
You can get most of these numbers from the seller. But a more efficient way is by using the services of a buyer’s agent. Experienced agents who know their way around investment purchases will clearly understand all the required data you’ll need. They’ll also have the know-how and connections to help uncover the trickier bits of data that can elude most buyers.
Crunch the Numbers and Find Your Monthly Cash FlowCrunch the Numbers and Find Your Monthly Cash Flow
Now that you have all the necessary data, it’s time to crunch the numbers and see what they tell you. One of the first things you’ll need to determine is the property’s monthly cash flow. This is how much money is flowing in and out each month through rent payments and property expenses. Naturally, you’re going to want a property that has a net positive cash flow. The higher your net cash flow is, the higher your ROI will be.
Calculating your monthly cash flow is relatively straightforward. All you need to do is subtract your expenses from your projected income. The tricky part is finding these numbers. You could try using the 2% rule of thumb, which states that a good investment is anything that can rent for 2% or more of the purchase price. However, this does not work so well in expensive markets like NYC. A better approach is to research what similar properties in the area are renting for. Don’t forget to take supply and demand into account as well. If there’s high demand, you may be able to set a higher rent.
Your expenses can be roughly estimated using the 50% rule of thumb, which states that your operating expenses will be about 50% of gross income. Unlike the 2% rule, the 50% rule tends to hold up pretty well regardless of where you’re buying. You can also get a clearer understanding of your potential expenses by talking with the seller, asking your buyer’s agent, and doing your own due diligence.
Calculate Your Annual ROICalculate Your Annual ROI
Now we come to the most important part of any investment analysis, calculating your return on investment. Depending on your investment strategy, there are a few ways to go about this. Below we’ve outlined the most common ones you need to know.
- Gross Rent Multiplier – This is the simplest way to calculate your ROI. It works by dividing the property’s price by its gross annual income. So, a property that costs $100,000 and rents for $25,000 a year would have a GRM of 4, meaning it would take four years to recuperate the initial investment. The lower your GRM, the better your investment is, at least on paper. However, GRM does not consider operating costs, market fluctuations, or loan amortization, so it shouldn’t be used solely when deciding on an investment.
- Net Operating Costs – NOR involves calculating how much income you’ll have once expenses have been subtracted. At first glance, this sounds like a cash flow calculation, but with one important difference. Unlike a cash flow calculation, it doesn’t include anything related to property financings, like income taxes and mortgage payments. NOR can be used to work out how much you’ll have left to cover mortgage payments. It’s also a good indication of how profitable the property is once you’ve factored out financing expenses.
- Capitalization Rate – Out of all the other methods, capitalization rate, also known as cap rate, is probably the most important. It aims to give you an idea of your return by assuming you purchased all-cash. This has the advantage of allowing you to compare two or more properties to see which one is the most profitable. You can determine a property’s cap rate by dividing its net operating income by its market value or purchase price. For example, a $100,000 property with an NOI of $8,000 would have a cap rate of 8%. Each investor will have their own benchmark for what they consider a good or acceptable cap rate. In general, you’ll want it to be as high as possible.
- Cash on Cash Return – Purchasing with the help of a loan can save you from paying a large sum out of pocket. But it also leaves you with additional monthly expenses in the form of mortgage payments. By using this method, you can analyze how profitable a financed investment purchase is. You need to divide your annual pre-tax cash flow by the total cash investment. You can find your annual pre-tax cash flow by subtracting your annual mortgage payment from your net operating income. The total cash investment includes everything involved in the purchase, your down payment, closing costs, and any other loan fees.
Run a Comparative Market AnalysisRun a Comparative Market Analysis
A CMA is the final piece of the puzzle and what ties everything together. Having worked out how profitable a potential investment is, your next task is to compare its asking price with similar properties that sold recently. Doing so will tell you whether it’s priced at a fair market value. Every investor and real estate brokerage will have its own methodology for calculating a CMA. It involves comparing a range of factors (called rental comps) that include the building’s age, square footage of the apartment, location, and many more. The best CRMs are the most thorough. You can protect yourself against overpaying and highlight properties that are priced below market value by performing one.
Final ThoughtsFinal Thoughts
There’s a great deal to consider when analyzing a real estate investment and this article only scratches the surface. Beginner investors would be advised to spend plenty of time reading and researching about every area of the investment game before getting their feet wet. This is a world that shows little mercy for mistakes and teaches tough lessons. But it’s also the road by which many people have achieved extreme wealth and financial security. Even if you’re not planning to become the next Warren Buffett, you can still achieve wonders with just a few well-thought-out investments.
Once you feel ready to try your hand with the investment game, ensure you enlist the services of an experienced buyer’s broker who knows their way around your local market. In terms of interpersonal skills, market knowledge, and insider connections, a good agent really can make all the difference when shopping for your first investment.