Analyzing real estate investments is important. By doing so, you’re likely both to make smarter investments—and to avoid costly mistakes. Unfortunately, most individual real estate investors have no idea of where to even begin. That’s too bad. In many cases, the analysis isn’t difficult.
Step 1: Calculate the property’s income capitalization rate
A key factor in your property’s return is its operating income. Essentially, the operating income is just the rental income less the property’s expenses (maintenance, property taxes, insurance, and so on).
The common way to look at a property’s operating income isn’t as an absolute dollar amount, however. Rather, you look at the property’s income capitalization rate. The capitalization rate (also referred to as the cap rate) is a simple percentage equal to the annual operating income divided by the property’s value.
Example: Just to keep all the numbers and arithmetic simple, say you buy a rental property for $100,000 and the property generates $6,000 in operating income. The capitalization rate equals 6% because $6,000 divided by $100,000 equals .06.
Step 2: Estimate the property’s appreciation rate
Operating income isn’t the only profit a real estate investor enjoys. Traditionally, real estate investors also see their properties appreciate over the long haul. On average, most properties will appreciate by the inflation rate. So that’s a good starting point for an appreciation rate guess. But some properties will appreciate (if only for short bursts of time) by more than the inflation rate. And then other properties won’t appreciate and may even fall in value, as happened during the Great Recession.
Forecasting appreciation rates is obviously difficult. But you need to take this step. If you don’t, you can’t complete step 3, which is described next.
Step 3: Estimate the real estate investment’s return
After you calculate or estimate the property’s income capitalization rate and come up with at least a rough estimate of the property’s appreciation rate, you can estimate the overall rate of return on the investment.
The overall rate of return on the investment is important because you compare rental property investments using this measure. To pick one property over another, for example, you should compare expected rates of return.
Fortunately, calculating the overall rate of return on investment with real estate is pretty straightforward. You calculate the overall rate of return by adding the capitalization rate to the appreciation rate. For example, if the income capitalization rate equals 6% and the appreciation rate equals 3%, the overall rate of return equals 9%.
This calculation, by the way, simply sets down in a formula a basic fact of real estate investing: Your return comes both from the property’s operating income and from any appreciation. It really is that simple.
An important note: You would select investments by comparing their rates of return. For example, to choose between a rental house in Bellevue and a small apartment in Redmond, you would identify which one delivers the higher overall rate of return. (This is easier to say than to do of course.)
Step 4: Factor in the effects of financial leverage
A few words about the effects of financial leverage: Investors can tie themselves in knots trying to forecast how leverage effects your investments. But if you’ve completed steps 1, 2, and 3, calculating the positive or negative effect of leverage is pretty easy.
To see how financial leverage affects your real estate investments, you compare the overall rate of return on your investment (this is the percentage you come up with in step 3) with the annual percentage rate (APR) that the mortgage lender will charge on money it lends. If the overall rate of return exceeds the APR, you have positive leverage and make more money by borrowing. If the overall rate of return falls short of the APR, you have negative financial leverage and you lose money by borrowing.
Example: If you have a real estate investment that will produce a 9% overall rate of return and you can borrow money at a 6% APR, you have positive leverage. Why? 9% is more than 6%.
You can estimate the precise dollar effect of your financial leverage by using this formula:
Leverage Benefit = (Rate of Return − APR) × Loan Amount
In the case where you invest in a property paying 9% using a $80,000 loan that charges 6%, you get a extra boost in your profits equal to $2,400. Here’s the leverage formula using these example numbers:
Leverage Benefit = (9% − 6%) × $80,000
Some Warnings about Real Estate Investment Analysis
The preceding paragraphs describe the basic investment analysis you should take to assess whether a particular property makes a good investment. But there are several complicating factors should be noted:
- Transaction costs can be very high with real estate investing. So if you buy and sell quickly, or “flip,” you need to factor in these costs too. (Over long periods of time—like decades—the transaction costs don’t matter as much.)
- For some investors, real estate depreciation creates an income tax deduction that (in effect) slightly increases the profit that flows from an investment. This tax benefit is often very modest, however. (In the example used earlier of a $100,000 rental house with $6,000 of operating income and $3,000 of appreciation, the tax benefit might equal $500 or $600 a year.)
- The lower the income capitalization rate you receive, the higher the appreciation rate you need in order to make up for the low cap rate, and, therefore, your rate of return. Remember the earlier example on this page of a property that pays $6,000 in operating income and appreciates $3,000 the first year? At a $100,000 price, as noted earlier, the rate of return equals 9%. At an $80,000 purchase price, the property delivers an initial rate of return equal to 11.25%. At a $120,000 purchase price, the property delivers an initial rate of return equal 7.5%. These are huge differences in returns, by the way. The person who earns 11.25% instead of 7.5% gets wealthy much, much faster.
- The only two big variables that you can control or forecast with anything approaching certainty are the price you pay and the rental income you earn. Which means investors should focus on these factors. Anything you do to get a better price or get a boost in your income dramatically boosts your rate of return. My observation is that smart, professional, experienced real estate investors forecast on price and income—not the stuff you see talked about on the cable television stations over the weekend.
A key part of our tax practice is preparing tax returns for real estate investors and helping them do smart tax planning for their investments. We supply these accounting services both to real estate investors in and outside of Washington State. We also help investors with large or very complex real investments forecast and analyze the cash flows from their investments. Please consider contacting our firm if you would benefit from this sort of assistance.