5 easy steps to understanding and analyzing Investment property
Looking to buy and investment property? Whether it be a single family home, an apartment building a commercial investment like a mini storage unit or perhaps an office building.
The investment you choose does not really matter as the analyses process is pretty much the same. Outside of the typical due diligence to check on the structure of the building you want to see how the property performs on your balance sheet.
5 things to identify when doing your due diligence.
Note when analyzing investment property you always want to consider items like closing costs and any lender fees. For simplification purposes the illustrations below are using easy numbers so you can quickly identify the process. when analyzing investments you always want to incorporate any and all expenses and fee. Here is a calculator that will make this process easy
1. True income and expenses: true income is verified income. This is usually found on the seller’s tax records. Often a seller will state income to be X but report a different income on their tax record. Using true income is paramount. Income is all income the property generates (rents, vending machines, Laundry machines, etc.). Expenses are all expenses related to the daily operations of the property, taxes, utilities paid by owner, property management fees, landscaping etc. Note: mortgage payments are not included when identifying total expenses as many investors purchase property with different terms. some pay cash some buy with 50% down payment as others finance up to 80% so each of these investors will have a different return on investment. For this exercise we want to analyze investment that will give a true picture of the returns.
2. Cap Rate (capitalization rate): This is perhaps the most widely used formula for identifying the performance of a property. it is a simple formula NOI / purchase price. Exp: purchase Price $100,000 / NOI $90,000 = 9% cap rate. So what is a good cap rate? This will vary by city and by the market conditions. The principle is to determine what an average cap rate is for previous sales in your area. Determine if you have a good cap rate for your area or not. Most investors have a set cap rate floor they are willing to invest in. a common practice is to have a cap rate at least 2 to3% higher than current prevailing interest rates. This way if you were to fiancé a property you would have positive leverage.
3. Net operating Income: a simple process of adding all income together, all expenses together to get annual income and annual expense. Then subtract the income from expense to get Annual Net operating income.
4. Cash on cash return. This is the process of establishing how much return your cash invested into the property generates. If you buy with all cash versus buying with say 75% financing your cash on cash will differ. Cash on cash return is your total out of pocket expenses minus your net operating income minus any mortgage. EXP; Investor A buys a $100,000 property and pays all cash. The expenses are $10,000 per year. So the NOI is $90,000. his cash out of pocket is $100,000 so the $90,000 represents his return on his $100,000 cash investment. $90,000/$100,000 so his cash on cash investment return is 9%. Now investor B buys the same exact property only financing 75%. So his cash out of pocket is only $25,000. $90,000 / $25,000 = 36 percent cash on cash return.
5. Cash flow: This is actual annualized profit you make NOI minus any mortgage.
Using above example the cash buyer has no mortgage so his net operating income is the same $90,000 as his cash on cash return. Buyer B however has a mortgage so his cash flow is his NOI of $90,000 less his annual mortgage payment. (Let’s assume his annual mortgage payment is $10,000) $90,000 NOI less mortgage payment of $10,000 = $80,000 in cash flow
Here is where it gets exciting
You can see The importance of structuring a deal. Investor A has a hot button of getting maximum cash flow. He does not want to carry mortgage payments so he gets a whopping $90,000 in annual cash flow.
Investor B has a hot button of getting higher cash on cash return. He only put $25,000 of his own cash in to the property so he gets a whopping 36% return on his cash. his cash flow is reduced by $10,000 per year as this $10,000 goes to mortgage payments.\
let’s assume Buyer B who only put $25,000 into this purchase actually had $100,000 cash to spend. By financing 75% he reduced his cash flow by $10,000 per year but if he used his $100,000 cash available to buy 4 exact properties like this one, he would now have 4 properties each worth $100,00 for a total of $400,000 worth of real estate appreciating in Value. He would also now have 4 properties generating $80,000 per year in cash flow (4x$80,000=$320,000) so 2 investors investing $100,000 each come out with 2 very different outcomes. \
This is the importance of creating your investment plan up front, Knowing what your goals are and being purposeful with your investments.