Analyzing Real Estate

One of the most important elements of real estate investing is knowing how to properly analyze a deal. This one task is what holds a lot of people back and what causes many to succumb to “analysis paralysis”.

To get comfortable with analyzing properties, set a goal to analyze a certain number per week. A good way to do this is to simply go to a website like Realtor.com or Zillow.com, type in the area where you would like to look for rental properties, and pick a few to start with. Once you go through this process for a few weeks, you’ll be able to scan through a listing and almost instantly know if it’s a good deal or not. Of course, whether it’s a good deal pertains to the location in which you are looking and certain market factors based on that location, but what I will describe here can be used as a general rule or metric to strive for.

I will note that I invest for cash flow and don’t really incorporate potential appreciation into my considerations. Although it would be nice if the property appreciates, I count it solely as a bonus, not as a deciding factor when purchasing real estate.

The One-Percent Rule

To narrow down to a specific property that may be a good investment, it’s good to have several “filters” that will help you easily weed out non-contenders. The first thing I look at is what is often referred to as the “One percent rule”.

1 month of rent = 1% of the purchase price + cost to get it “rentable”

The cost to get it rentable factor only applies if you don’t buy a turnkey property that doesn’t require any work.

So, as you can see, a very simple math equation is what I use as the first “filter”. For example, if a house costs $100,000 and needed no work in order to be rented, you would want to collect at least $1,000 in monthly rent. ($100,000 X 1% = $1,000)

If the house costs $100,000 and you estimate that it will need $20,000 in work, then you’ll want to be able to collect at least $1,200 per month in rent. ($120,000 X 1% = $1,200)

If the rent I know I can get for the house falls far below this rule, then it’s out of the running. If it comes close then I may still consider it based on other factors that I’ll describe below.

Design of House

By “design” I mean factors such as the shape of the roof, material used for siding, heating system, layout, etc.

The ideal rental house looks like a boring brick box. You have to zone out thinking about the house as if you were the one living there. The more boring the better.

You don’t want a steeply pitched roof that would cost a fortune when it needed to be replaced.

You also don’t want a high-maintenance siding such as cedar that would need to be painted every so often.

I also like houses that are only one level with perhaps a basement. Having an upstairs just adds to the complexity and carries the risk of a water accident happening and ruining the top level as well as seeping through the floor and coming into the main level. Also, the liability of someone falling down the stairs.

I don’t like the idea of having a rental house with something like oil heat, a wood stove, fireplace, or gas logs as the heating source. Ideal heating would involve either natural gas, electric heat, or a heat pump. With oil you’d have to worry about leaving the tenant responsible for calling the oil company to refill it, which I wouldn’t hold out hope for, so then the burden might fall on you. They could let it go empty and then just start running space heaters instead – also not good. Anything involving fire and tenants gives me the chills. I do not want the tenant cutting wood in my yard (possibility of getting cut with a chainsaw or ax) or doing anything that involves fire and the house. One of our rentals does have a wood burning fireplace but I’ve included in the lease that under no circumstances is it to ever be used. I think in the future I may actually seal the chimney or brick up the fireplace to reduce the risk of it being used.

If the house doesn’t pass my “boring box” test then it’s thrown out – unless it has other redeeming qualities.

Resale Potential

You always need to have an exit strategy for your investments. One thing I’m always thinking of when looking at a deal is “how easily could I get rid of this if I had to in the future.” This is one reason that my strategy for now focuses on purchasing 1-4 unit properties. With a single family property, you are at the price point where you could sell it to someone wanting a permanent home, or an investor who may just be getting started in their investing career. Due to the lower price point of 1-4 unit properties, there is a lower barrier to entry, meaning more buyers.

We recently looked at an older 6-unit apartment building that was for sale. It had great cash flow but was built in the 1940’s. The one thing that kept nagging at me was what I would do with it if I ever wanted to get out of it. It was at the price point that not just any person would be able to afford it so I would be relying on a smaller buying pool. I think this decision was a good one because the seller of this property has had to drop the purchase price by $80,000 and still hasn’t found a buyer.

Location, location, location

What are the three most important words in real estate? Location, location, location. I’ve heard of people investing in real estate in places they’ve never been and relying on other people to tell them if it’s a good place or not but I believe you should be very familiar with the area before you invest. In my opinion, I think it’s best to choose either where you grew up, where you’ve lived in the past, or where you currently live. By living in the area that you’re investing in, you should have a very good sense of if it’s a good area or not.

Where I live, there are good parts of town and no so good parts. If I didn’t live here, I might see a listing on the internet for a $20,000 house and think “Wow! There’s no way I can pass that deal up.” And I never would know that the house is located on the wrong side of the railroad tracks in a neighborhood that I wouldn’t want to walk through at night.

Another of my criteria is “Do I feel safe here and would I feel comfortable here at night.” Sometimes I’ll drive around all the different neighborhoods just to see what’s going on, look at the condition of the houses, etc. so that when I look for a property to buy I’ll know if I shouldn’t even bother looking at it due to the neighborhood it’s in. You should also drive around neighborhoods you’re interested in investing in at night to see what’s going on. When I was looking into the apartment building that I described earlier, I would sometimes go park across the street from it and just watch the activity that happened around it. It gives you a greater sense of the area than just driving by on occasion.

What are some factors that I look for in order to determine if it’s a good neighborhood or not? One strategy is to drive around in the daytime on a weekday. I can’t utilize this strategy much since I work 30 minutes away but it lets you see how many people may be out walking around or just sitting on their porch when everyone else is out working.

Another thing I look for is how many people are walking on the street. Yes, they may be just exercising but it will be obvious to you if they are walking for exercise or walking for transportation. I will say that this town is not very walker friendly (hardly any sidewalks) so most everyone drives unless they cannot afford transportation.

Do the houses look well-kept or are they neglected and in need of major repairs? Is there pride of ownership? Do people have lawn decorations and porch furniture? (Not the living room kind). I’ve discovered that if people tend to leave out nice porch furniture and decorations, they aren’t afraid that it will get stolen, so the crime is probably low.

Don’t be afraid to call the local police station and ask them questions about the neighborhood. My realtor and I were looking at a foreclosed house that had been pretty trashed but it seemed to be mainly cosmetic issues. It did have a pretty funky smell but I figured it was due to it being shut up so long and cigarette smoke. My realtor has seen a lot of houses and I think he knew something was up with this one so he told me to call the police department and ask if there had been any reports of meth related to the house. I thought that was a little weird but did it anyway. It turned out that yes, there was a report that the last occupant had been arrested for making meth in the house. If I hadn’t called the police department, I never would have known this fact and I probably would have bought the house because it was pretty new and such a good price. You may be thinking “Isn’t it mandatory for the seller to have to disclose something like that?” Yes, but only if they “know” about it. Since a bank was selling it I guess it’s possible they didn’t have knowledge about it but it’s hard to say.

Capitalization “Cap” Rate

Now for the complicated part. All of the factors above involve hardly any math and mostly rely on intuition and visual inspections. This judging criteria is strictly numbers based. I think it’s good to complete the “numbers analysis” prior to getting in too deep and getting to the step of surveying the house from afar at night. The property may pass the numbers analysis with flying colors and then be in a horrible location, or maybe the numbers are kind of weak but it’s in such a great location and you think rent rates may increase soon, or you can easily create some sort of value-add so it may deserve an in-person look.

There are two things I use Cap Rate for: To estimate a return on a rental property investment, or to see if the asking price is a fair price to pay for the property in question.

First we will look at using a Cap rate to estimate the potential return on a rental property investment.

Capitalization Rate = Net Operating Income / Current Market Value (Purchase Price)

Net operating income is calculated by taking the gross annual rental income and subtracting all operating expenses (not to include interest and depreciation). When I’m analyzing a property and may not know the operating expenses at first, I usually use a conservative figure of 25% of gross rent.

Using our $100,000 example: Net Operating Income = Annual Gross Rent – Operating Expenses

$12,000 ($1,000 per month X 12 months) minus $3,000 (25% of $12,000) equals $9,000 Net Operating Income (NOI)

Are you still with me? It’s not that hard, I promise. Just stick with it.

So, Capitalization Rate = $9,000 (NOI) / $100,000 (Purchase Price)

Capitalization Rate = .09 or 9%

So what does this mean? It means that every year, you will earn 9% of what you paid for the property – assuming the net operating income stays the same.

I look at it kind of like returns you would receive on a stock market investment.

So is a 9% Cap Rate good? Well, it depends. Higher Cap Rates are typically associated with higher risk properties – so a house in a less affluent neighborhood or a strip mall with local tenants on a one year lease. Higher risk = higher reward.

Lower Cap Rates are typically found in a house in a wealthy subdivision or a nationally recognized brand such as a Walmart or Sheetz. Lower risk tenant = lower reward.

Keeping this in mind, you can also reverse the equation and determine the price you are willing to pay for something based on a certain Cap Rate.

The numbers in the chart above were calculated by dividing our NOI ($9,000) by the various Cap Rates. $9,000 / .09 (9%) = $100,000

Continuing our example, we can look at this chart and determine what we think is a fair market value based on the correct Cap Rate.

But what is the “correct” Cap Rate? It depends. Most real estate investors have an idea of what the typical Cap Rate in their area is for a certain type of investment - be it a single family home, an apartment building, or a shopping center. This knowledge is gained from talking to other investors or looking at enough deals that you know what the going Cap Rates are for your location.

Looking at the chart, you can see that Cap Rates and Property Values have inverse relationships. As Cap Rates rise, the value of the property falls and vice versa. With a 6% Cap Rate, you’ll have a more valuable property but the return won’t be as high. With an 11% Cap Rate the property will be worth less but you’ll be making a higher return.

For my own investing purposes I like to have a Cap Rate of 9% or higher.

A Capitalization Rate can also be used to calculate the payback of a property – how many years it will take for rent to pay for the entire purchase price of the property. Simply divide 100 by the Cap Rate expressed as a whole number. 100 / 9 (9%) = 11.11

If everything goes according to plan, the tenant will have paid you back for the purchase price of the property in a little over 11 years.

Conclusion

I hope I didn’t lose you with that last part. As you can tell by the length of this article, analyzing real estate can be a very daunting task which can easily lead to “analysis paralysis”. It takes a lot of intuition and judgement – not just number crunching. You have to know how to do the math but you also have to know about the neighborhood, buying and selling history, and market rent and purchase prices.

It can be very overwhelming so you need to spend time learning. You need to read books, talk to other investors, and listen to podcasts. It’s a constant learning process with an almost unlimited amount of sources to learn from. The inspiration that began my real estate journey was by reading the book “Rich Dad Poor Dad”. Reading this book will probably motivate you to remain curious and delve in deeper.

Real estate investing may not be for everyone but I believe it has the potential to accelerate your wealth and cash flow if you spend time doing your due diligence and continue to learn and expand your knowledge on the topic. 

“The key to earning is continual learning.”