Real estate investments can make you wealthy, but they can also sink your finances (if you aren’t careful). So before investing in any type of property – commercial, residential, or land – always perform careful and comprehensive due diligence.
How to Analyze Any Investment Property
Due diligence is basically the process of researching and vetting a property before making a purchase. It involves calculations, document review, walking the property, and speaking with others in the industry. It’s essentially the act of doing your homework as a means of taking precaution against investing in a bad deal.
Not sure where to begin? Here are some practical suggestions for analyzing any investment property:
1. Comparative Market Analysis
It’s imperative that you get professional advice and use objective data to remove as much uncertainty from the equation as possible. The first step in doing this is pulling a property report, which includes a comparative market analysis.
A good comparative market analysis will provide an estimated property value, median sale prices in the area, a list of properties recently sold in the area, property mapping, market comparisons, and insights on the demographics of the neighborhood. Based on this information, you can get a feel for whether the listing price/offer is competitive.
2. Capitalization Rate
Armed with a comparative market analysis, you can move on to some specific equations that will empower you to objectively analyze your potential return on investment (ROI).
The first thing to look at is the capitalization rate (also known as the cap rate). The formula is pretty simple:
Cap Rate = Net Operating Income / Total Cost
Your net operating income is based on gross rents minus all of your expenses (excluding the cost of financing). Generally speaking, you want a cap rate of at least 6 percent – though 9 or 10 percent is considered ideal.
3. Price-to-Income Ratio
This is a helpful little metric that can empower you to make wise decisions about when and where to invest. It’s a simple one:
Price to Income Ratio = Median Household Price : Median Household Income
You can run a price-to-income ratio for the neighborhood or zip code. It basically tells you the affordability of housing in that market. In other words, will you be able to attract the type of renters you’re seeking. (It’s not a perfect calculation, but it’s a quick and easy rule of thumb.)
4. Cash Flow
At the end of the day, cash flow is what matters. Too many inexperienced investors get caught up in appreciation and future market value. And while it’s nice to have an investment property grow in value, the reality is that you’re looking for a return on your money. The way you get this return is by generating positive cash flow month after month after month.
Cash Flow = Rental Income – Total Expenses
If this number is positive, you’re making money. If it’s negative, you’re losing money. Plug this number into the cash on cash return equation and you get a clear picture of what this means for your investment.
5. Cash on Cash Return
While cap rate doesn’t account for financing, the cash on cash return equation does. It basically tells you how much value you’re getting in return for the cash you’re putting up. The equation looks like this:
Cash on Cash Return = Pre-Tax Cash Flow / Total Cash Invested
You typically want something in the range of 15 to 25 percent, but at the end of the day, this equation isn’t the most important. The more leveraged you are, the higher the ration will be. So only use this equation in addition to the others on this list.
Neutralize Your Emotions
In any investment situation, there are two brains at work. There’s the emotional brain and the logical brain. A due diligence process that’s controlled by the emotional portion of your brain will increase the likelihood that you make a mistake.
Emotional investing can be tied to the fear of missing out and/or an obsession with a specific characteristic of a property. These types of deals often lead investors to overpay and/or combine investment and owner-occupied objectives. (For example, you start to see yourself in the property, even though it’s meant to be a rental.)
To be a successful investor, you have to neutralize your emotions. The best way to do this is to trust the numbers. Run a comparative market analysis and various ROI formulas and let the data tell you whether it’s a good investment or not.