In real estate investing, money is made when the property is purchased, not when it’s sold.
That’s another way of saying that the more thoroughly you analyze real estate deals, the greater your odds of success. Here’s how to analyze real estate deals, even if you’re a brand new rental property investor.
Difference Between Price and Value
Before you analyze a potential real estate deal, it’s important to note that there can be a big difference between price and value. As Warren Buffet sagely observed, “Price is what you pay; value is what you get.”
We all know what price is. For example, if a 2-story single-family home has a fair market price of $200,000 in a balanced real estate market (a balanced market is one that doesn’t favor either buyers or sellers), an owner-occupant is likely to pay the asking price of $200K.
However, the same house might be worth much more than $200,000 to an investment property. That’s because the investor plans on adding value to the property by turning each floor of the house into individual rental units.
Let’s say each unit generates a net operating income of $750 per month (after operating expenses but before debt service) or a total of $18,000 per year for both units. If the going cap rate for a small multifamily property in the market is 6%, the house would be worth $300,000 to the investor based on the cap rate formula:
- Cap rate = NOI / Property value
- NOI / Cap rate = Property value
- $18,000 annual NOI / 6% cap rate = $300,000
That doesn’t mean the investor will pay $300K for the house. There are additional construction expenses and permitting fees to turn the home into two rental properties, and also because the price for single-family homes is calculated differently than multifamily. But when everything is said and done, the buyer will be the proud owner of a nice cash-flowing property worth much more than the current asking price.
How to Determine Property Market Value
In the above section, we discussed what a property could be sold for, assuming the single-family home had been turned into two rental units. For the purposes of this section, we’ll define property market value as the price that a property can be sold for.
You’ve probably heard other real estate investors or agents talk about “running comps.” Comps – which is another word for comparative market analysis or CMA – is a report used to predict the current market value of a property based on recent sales and active listings of homes in the same area that are similar to the one you are analyzing.
There are several ways to create comps, even if you’re still building your real estate team and don’t have an agent lined up:
- MLS is used by real estate agents who are part of their local real estate association to generate a comparative market analysis.
- Zillow is a free public database that real estate investors and the general public can use to estimate the value of a home based on similar homes for sale and recent sales.
Price adjustments usually need to be made to a comparative market analysis because every property is unique and different, even houses within the same subdivision. When making adjustments to a CMA, the idea is to make the comparative homes as similar as possible to the home being analyzed.
Common adjustments to comps include:
- Square feet
- Floor plan
- Lot size
- Age of construction
- Recent improvements
Assume that a subject home you are analyzing is exactly the same as a comparable home across the street the sold last month, with one exception: the comp home has a brand new air conditioning system, and your subject home has an HVAC unit that is 20 years old and will need to be replaced in the not too distant future.
You make some phone calls and learn that a new HVAC costs about $8,000. If the house across the street sold for $200,000 the home you are analyzing would have a market value of about $192,000, provided that all other features between the two homes were the same.
Single-family home market values
The property market value for a single-family home – which is the price the home can be sold for - generally doesn’t change if the home will be used as a rental. That’s because house prices are based on comps such as size of the home and number of bedrooms, not the potential income the property could generate as a rental.
However, prices of rental homes should rise in value if other similar homes are rising in value, or decrease in value if the prices of similar homes are also cycling downward. Later in this article, we’ll discuss some of the key metrics and formulas used to value a rental home and to learn if the value of the home being analyzed is greater than the market price of the home.
This includes 2-4 unit properties as well.
Multifamily home market values
The property market value for commercial multifamily homes – 5+ units – is based on the income the property generates in addition to the property features such as age of construction and recent improvements. That’s because multifamily homes are specifically built and purchased for the rental income they generate.
Compile Property Information
The second step in analyzing a real estate deal is to gather information on the property. Key property and financial data to compile includes:
- Property details such as square footage, number of bedrooms and bathrooms, and number of units for a multifamily property.
- Purchase information including price, closing costs, and repair estimates.
- Financing details such as loan amount, down payment, interest rate, and prepaids.
- Rental income from monthly rents and additional fees such as pet rent or appliance rental.
- Operating expenses including routine repairs and maintenance, capital reserve contributions to save for major repairs, property tax and insurance, and property management fees.
Beware of rental property listed for sale using pro forma data versus actual data, because sellers may try to make a property seem more valuable by overstating potential income and understating estimated monthly expenses. Good sources for actual data include:
- Seller tax returns for the property, usually Schedule E on a personal return
- Property tax bills
- Actual maintenance records if the property is already a rental
- Property management reports
- County records showing recent sales transactions and property tax data
Conduct Financial Analysis
Once you’ve compiled all of your information and ensured it is as accurate as possible, the third step in analyzing real estate is to conduct a financial analysis. There are two parts to the financial analysis: Financial measurement metrics and benchmark rules you can follow to help analyze a deal.
- Income includes rents received plus extra income from items such as late fees, pet rent, or appliance rent
- Expenses include the costs of owning and operating the rental property such as repairs and property management fees
- Net operating income (NOI) = Income less expenses, before debt service/mortgage payment
- Cap rate = NOI / Property price
- Cash flow = NOI less debt service
- Cash-on-cash return (CoC) = Cash flow / Investment basis
- Return on investment (ROI) = Cash flow / Investment basis (down payment and capital improvements)
- Internal rate of return (IRR) = a measure of annualized net return on an equity investment. It equals the discount rate at which the sum of the present value of all cash flows is zero. The calculation is based on actual and budgeted values.
Here’s a quick look at how the financial measurement metrics for a rental property work.
Assume a single-family rental home with a market price of $100,000 was purchased using a down payment of $25,000 and has a monthly mortgage expense (P&I) of $320:
- Income = $1,200 per month or $14,400 annually
- Expenses = $600 per month (excluding debt service) or $7,200 annually
- NOI = $14,400 income - $7,200 expenses = $7,200 annual NOI
- Cap rate = $7,200 NOI / $100,000 property price = 7.2%
- Cash flow = $7,200 NOI - $3,840 annual debt service = $3,360
- Cash-on-cash return = $3,360 cash flow / $25,000 down payment = 13.44%
- ROI = $3,360 cash flow / $25,000 down payment investment basis = 13.44% year one
If you’re looking for a visual example of the above, here’s one of our coaches from Roofstock Academy editing the income and expense expectations on a listing to see how it affects the property:
- 1% rule is a rule of thumb rental property investors use to decide whether or not a property is worth taking a closer look at, and means that the gross monthly rental income should be at least 1% of the property purchase price.
- 2% rule is a more conservative version of the 1% rule and means that the gross monthly rental income should be at least 2% of the property purchase price.
- 50% rule states that operating expenses (excluding debt service) will average out to about 50% of the rental income.
- 70% rule is used for buying property that needs a significant amount of repairs before it can be rented, and states that the purchase price plus repairs should be 70% of the after repair value (ARV).
- Debt service coverage ratio (DSCR) compares the NOI to the debt payment, with lenders typically requiring a DSCR of 1.25 or higher. The DSCR for our example house would be: $7,200 NOI / $3,840 debt service = 1.875 DSCR, well above the ratio a lender would look for.
Final Thoughts on Analyzing Deals
Experienced rental property investors analyze real estate deals using all of the various metrics and benchmark rules we’ve discussed.
The more information you have when analyzing a potential real estate investment, the more likely it is that your rental property will generate solid and consistent returns year after year.