How to Analyze Real Estate Investment Properties

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It’s common knowledge that one of the best investments you can make is in real estate. According to the S&P 500 Index, the average annual return on an investment for real estate in the United States is 10.6%. And with the volatility in the stock market and cryptocurrencies in a state of flux, there is arguably no better investment to make right now than in real estate.

Whether you’re a long-time investor or are looking to scoop up your first property, there are some dos and don’ts when it comes to income property analysis. Here are some tips for analyzing real estate rental properties and steps to get started.

What Is an Investment Property?

Just as it sounds, an investment property is “any real estate property purchased with the intention of earning a return on the investment either through rental income, the future resale of the property, or both.” Rental properties are the most common investment option, as they can reliably generate steady income and allow you to retain ownership of the property, accruing more wealth as the property appreciates in value. 

Rental properties are solid investments, if you don’t overspend and can depend on a reliable return. Determining this comes down to several property and market factors, beginning with the type of property you purchase. For analysis purposes, we will be focusing strictly on rental investment properties.

Types of Rental Properties

There are different types of rental properties, based on their intended use. The most common are:

  • Residential
  • Commercial
  • Mixed-use

Property Analysis 101

There are many factors that impact both the value and ROI of a rental property. When conducting an initial rental property analysis, consider these factors.

  • Location: the location of the property. Is it centrally located? Is it near amenities that would make it appealing to renters? Is it in a saturated or under-saturated market?
  • Income and Cash Flow: This refers to the amount of money you can generate from this rental property. What is a reasonable rent to charge for this property? Do you have access to consistent tenants? Will the building be consistently occupied?
  • Property Type: The property is either residential, commercial, or mixed-use. Do you have flexibility when it comes to the intended use? Do you have experience as a landlord for this type of property?
  • Vacancy Rate: This refers to the percentage of all available units that are vacant or unoccupied.
  • Operating and Capital Expenses: These are the costs associated with owning, managing, and maintaining the rental property. How much are the taxes? Are there HOA fees? Are there required upgrades?

8 Common Valuation Methods for Property

Analytically speaking, there are several valuation methods investors use to determine whether or not a rental property is worth it. Each uses different formulas and algorithms, based on the investor’s goals, asset value, and other influencing factors.

  1. Cash Flow

Cash flow is the amount of money an investment generates each month through rent after considering the property’s expenses. To determine cash flow, subtract the total operating costs and mortgage payment from the total rental income value. 

  1. Internal Rate of Return

Internal rate of return (IRR) is the annual rate of growth that an investment is expected to generate. IRR is determined using the following formula:

  1. Capitalization Rate

Also known as the cap rate, this is the rate of return that is expected to be generated on a real estate investment property. It is determined by dividing a property’s net operating income by the current market value.

  1. ROI

Return on investment (ROI) is the expected profits from a rental property, as a percentage. To solve for ROI, take the estimated annual rate of return, divide it by the property price, and then convert it into a percentage.

  1. Sales Comparison Approach

A sales comparison for property analysis compares one property to comparables recently sold properties — otherwise known as comps — in the area with similar characteristics. This is not a formula, but more of a broad analysis that considers things like location, recently sold listings, property features, property condition, and more.

  1. Value Per Gross Rent Multiplier

Value per gross rent multiplier measures and compares a property’s potential valuation. It is determined by taking the price of the property and dividing it by its gross income, or Gross Rent Multiplier = Property Price or Value / Gross Rental Income.

  1. Cost Per Rentable Square Foot

Rentable square footage combines the usable square footage (the space tenants can occupy) with the common areas tenants will access to determine the cost per rentable square foot compared to the average lease cost per square foot.

  1. Value Per Door

Value per door is the entire rental property’s worth based on the number of units and the income each will generate. To solve, simply divide the sales price by the number of units in the building.

How to Decide if a Property Is a Good Investment

A “good investment” is not clearly defined and will mean different things to different people. And not all rental properties will have the same return, nor will they necessarily generate the exact value that you calculate using one of the aforementioned equations. 

Ultimately, the investment property analysis and the actual profits earned probably won’t line up exactly. That will depend on the work you do as an owner, and the evolution of the market over time. But regardless of mitigating factors, there is a quick rule of thumb to use to determine whether the property is a good investment.

It’s called the 2% rule. This applies to any investment, and says that an investor will risk no more than 2% of their available capital on any single investment. In real estate, this means that a property is only a good investment if it will generate at least 2% of the property’s purchase price each month in cash flow. This 2% figure should be the baseline; if a property will generate more than 2% of the total monthly, it is definitely a good investment.

Determining what your cash flow will be is the more difficult part of this equation. To determine monthly cash flow, consider the following factors:

  1. Rental revenue
  2. Monthly mortgage 
  3. Property taxes
  4. Mortgage insurance
  5. Additional Expenses
    • Home insurance
    • Maintenance costs
    • Management costs
    • Utilities

If you’re interested in real estate investing or are looking to jump into a commercial real estate career, consider furthering your education on the subject. 

Real estate is an ever-changing industry with evolving regulations and best practices to be mindful of. At the University of San Diego Division of Professional and Continuing Education, we proudly offer a Real Estate Finance, Investments and Development certificate

This program is designed for aspiring real estate professionals who seek to gain essential skills in financing, developing, managing, and selling commercial real estate. Through our innovative course work, you will learn the latest real estate development strategies that are necessary to compete in today’s changing market

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