Real Estate Investment Analysis - An Introduction
Real estate investment analysis is an artform that all current and future investors should have an understanding of. Although it can be a complicated, often confusing, undertaking, it is vital for making educated investment decisions.
In this article, we cover what you need to know to get started with real estate investment analysis, including:
- Choosing a property type
- Determining the value of the real estate investment
- Collecting information
- Assessing property income
- Calculating expenses
- Analyzing property performance metrics
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Choosing A Property Type
Before analyzing an investment, the type of property being invested in must be identified. This could range from common property types like residential, commercial or industrial, and office, to less common properties like agricultural or special purpose such as data centers, for example. No matter which property type is chosen, proper investment analysis is key to ensuring its success.
Determining the Value of the Real Estate Investment
Regardless of the type of property being invested in, the primary objective of any pre-investment process is to have a good understanding of its value to ensure any proposed business plan will deliver targeted returns. There is a much higher probability that an investor will inadvertently overpay for a property without the proper analysis than there is that they will underpay and, as is often said in commercial real estate, the money is always made when an asset is bought, not when it is sold.
To determine the value of the real estate investment, one of two methods are commonly used: comp analysis and income analysis.
Comps, or comparables, are used as a way to value a property based on what similar properties in the area have recently sold for. Most often seen in the single-family home market but also utilized for commercial real estate, comps work well in markets with a relatively high sales volume of properties similar to the one being invested in. Adjustments can also be made to comps to account for differences in the properties, like better amenities or a larger or more efficient floor plate.
Comp analysis is more straightforward to perform in states that require disclosure of the financial terms of real estate transactions but is also possible in “non-disclosure” states with the proper amount of research.
As the name suggests, income analysis uses the property’s projected future income to determine what its value is today. This method is commonly used in the commercial real estate world and for residential properties with two or more units.
Unlike comp analysis that relies on the valuation of other properties to determine the value of the target property, income analysis only utilizes the financial performance of the property in question to determine its value. Once the cash flow is determined, an investor can simply apply a cap rate or other performance metric to determine what the property’s price should be.
Income analysis is typically more complicated than comp analysis and requires a more thorough understanding of the property’s financials, but it can also be a powerful way to underwrite an investment and calculate its true monetary value.
To do investment analysis, the investor needs to collect as much information about the property as is feasible. Details ranging from the size of the property and the number of units to the property’s current vacancy and tax obligations all need to be taken into consideration and accounted for in the calculations.
Some of this information will be provided by the seller, while other pieces will require independent research.
It is difficult to analyze a property without having all of the details, so being thorough during the information collection process is key.
Pro-forma vs. Actual Data
Pro-forma numbers are provided by the seller, usually in the form of an offering memorandum (OM) or rent roll. An OM usually includes a property’s current vacancy rate, rental rate, taxable value, and forecasts or “estimations”. Even though this information is provided, it’s always in the best interest of the buyer to do their own and thorough due diligence process.
For the most part, data provided by the seller will need to be confirmed, and any forecasting should be done by the investor themselves in the due diligence process. During the due diligence process, it may be discovered that the property requires extensive renovations or will soon be competing with a newer, nicer property next door in a few years, both of which the seller probably failed to mention. By the time the transaction makes it to the closing table the investor needs to be confident in the accuracy of their analysis, and the only way to do that is by finding the actual data themselves.
Where to Find the Data
There are a number of places to find the data necessary for the investment analysis, most of which are readily accessible.
For the property’s basic details like size and year built, the seller can typically be relied upon to provide accurate information. The county’s property records can also be referenced for confirmation, and investors may also be well served to request floor plans and blueprints of the property depending on the type of transaction.
Information related to the property’s condition, maintenance issues and renovation requirements can be found by having the property inspected. The inspection team will look at the property’s physical condition in much greater detail than a typical investor would, even going so far as to look at the building’s electrical, HVAC and water systems. Inspections are an upfront cost but are well worth the expense since they can help avoid an unexpected renovation or repair bill later on.
The investor can also talk with the building’s property management company if one is being used, as it will know the details related to the day-to-day operation of the building. The property manager should have detailed records related to the property’s income, expenses and tenants that you can request. The investor should also confirm the property management company’s fee and begin thinking about whether the existing management company will be retained or if a new manager is needed.
While the property’s rent roll will likely be provided in the offering memorandum and due diligence items the seller produces, the investor may also want to review the leases of each tenant in detail. Some tenants may have renewal rights or special terms in their leases that could derail future transactions if they are not accounted for ahead of time, so reading through each lease in detail is an advisable practice. It may also be worth the investor’s time to meet with the larger tenants in the building to collect their feedback related to the property and their lease.
Lastly, institutional-grade transactions will almost always involve some form of financing, so information pertaining to loan terms will need to be collected as well. It will be necessary to contact all potential finance sources, lenders and brokers to gather their perspective on the acquisition and begin assessing what terms and rates they may be able to offer.
Assessing Property Income
Now that the necessary data has been collected and there is a good understanding of how the property should perform moving forward, it is time to assess the potential future income.
To do this, a look at the property’s current rent roll can help determine if there are any areas for improvement. Are tenants currently paying below-market rent? Is there a large vacancy that can easily be filled? Are lease expirations staggered, or will you have a high volume of expirations happening at the same time? Finding the answers to questions like these will help determine what the property’s income is likely to be moving forward.
It is also important to analyze the local market in order to make accurate predictions. Proper market research will help the investor understand whether rental rates are increasing or decreasing in the area, what lease terms are being offered by other landlords and where areas of growth are located. Research can also help uncover whether the target property has any advantages or disadvantages compared to competing properties that could impact its future success, such as larger floor plates, a superior amenities package or better common areas.
At the end of this process the investor needs to have a good understanding of not only what the property’s income is today, but what it can be expected to be over the entire investment horizon. The investor should also pay particularly close attention to what the property’s income will be when it is time to sell, as that income will play a significant role in determining what the property will sell for down the road.
Along with calculating the property’s income, the investor also needs to calculate the property’s expenses using the collected information.
Common expenses like repairs, capital expenses, property management fees and property taxes are easy enough to calculate and should obviously be included in the investment analysis. However, less common expenses like advertising, landscaping and utilities should also not be forgotten. While these expenses are unlikely to make or break an investment, they could make the investment’s returns appear less appealing than you had originally calculated.
It is also important to account for the expenses related to leasing space in the property. Most transactions will require the landlord to pay brokerage fees, and some transactions may require tenant improvement allowances or other concessions that the investor will need to pay for. Although high leasing expenses typically mean large, profitable leases, the profits of those leases are realized over time while the expenses must be paid for upfront.
Analyzing Property Performance Metrics
Once due diligence is complete, the property’s value has been determined, data has been confirmed and income and expenses have been calculated, it is time to analyze the property’s performance metrics. The following are some of the most useful and relevant metrics below.
The cash flow of the property is its gross income, less expenses and debt service. For example, if the property generates an annual gross income of $3,000,000, has expenses of $1,000,000 and debt service of $800,000, the property’s cash flow is $1,200,000.
This calculation is similar to the commonly used net operating income (NOI) calculation, which does not subtract debt service from gross income. NOI is also typically a pre-tax calculation, so the property’s tax obligation is also not deducted.
The capitalization rate, commonly referred to as the cap rate, is calculated by taking the property’s annual NOI and dividing it by the property’s purchase price. The cap rate is a helpful metric for understanding the property’s annualized return regardless of financing expenses. This is the equivalent in traditional stock investing of the yield. A lower cap rate means a lower return on invested capital and a higher purchase price.
The formula for cap rate can also be used as a quick way to estimate the value of the property. By flipping the formula and dividing the property’s NOI by an estimated cap rate, the investor can get a rough idea of what the property is worth.
Internal Rate of Return
The internal rate of return (IRR) shows the annualized return of the property over time, taking into account the time value of money. The IRR is the discount rate that makes the net present value of all the forecasted cash flow equal zero. Ceteris paribus, the shorter the investment horizon the higher the IRR of the investment.
Similar to a typical return on investment calculation, the cash-on-cash return is the property’s cash flow divided by the initial equity in the investment. For example, if the property generated cash flow of $1,000,000 in a year and the initial equity was $5,000,000, that year’s cash on cash return is 20%. The cash-on-cash return is typically viewed on an annual basis and will be considered “good” or “bad” depending on the investor’s own investment goals.
Total Return on Investment
The total return on investment is the true, dollar-for-dollar return on the investor’s money over the investment horizon. Adding up all the property’s income, subtracting out all of the expenses and debt service and then dividing by the initial equity in the property will tell what percentage return can be expected. This calculation is similar to IRR, though does not account for the time value of money.
Digging into the numbers and gaining a true understanding of the potential risks and returns of an investment can be time-consuming and tedious but is a vital step in making an educated investment decision. The processes described in this article offer a high-level overview of some of the key components involved in analyzing an asset.
Acquiring real estate and executing on a business plan is a complicated process and at Rising Realty Partners we spend a considerable amount of time looking at any potential acquisition. Contact us to learn more about the intricacies and extent to which our seasoned team of professionals drill down on all aspects of an investment analysis.
Casey leads the investor relations team at Rising Realty Partners and is responsible for growing the community of accredited investors, fostering investor engagement, and raising capital.