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 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, also know as the "cap rate," equals
6% because $6,000 divided by $100,000 equals .06. (.06 is the same thing as
6%.)
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. 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.
Forecasting appreciation rates is
obviously difficult. But you need to take this step. If you don't, you can't
complete step 3, which I describe 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: You can tie yourself 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
effects 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
and warnings I want to make:
•
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 of a property that pays $6,000 in
operating income and appreciates $3,000 the first year? At $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 my tax practice is
preparing tax returns for real estate investors and helping them do smart tax
planning for their investments. I can supply these services both to real estate
investors in and outside of the Redmond, Bellevue, Seattle area. I also help
investors with large or very complex real investments forecast and analyze the
cash flows from their investments. Please consider contacting me if you think
you may benefit from this sort of assistance.
By Stephen L. Nelson specializes in serving
business owners and other individuals with complex finances or taxes. A CPA for
three decades, Nelson holds an MBA in Finance from the University of Washington
and an MS in Taxation from Golden Gate University. Nelson is the author of
dozens best-selling books about accounting and finance including Quicken for
Dummies (which sold more than 1,000,000 copies) and QuickBooks for
Dummies (which sold more than 500,000 copies). He's also taught LLC and S
corporation taxation in the graduate tax school at Golden Gate University.
