Real Estate Fundamental Analysis: Four Basic Steps

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The news has been saturated with reports about the financial bailout, the Secondary Mortgage Market, Securities and Derivatives. In these troubled times, it is important to understand the fundamentals of Real Estate analysis. There are a variety of models and tools that can help us better understand changes in market conditions and can even simulate probable ranges of value under different economic scenarios. I will be exploring how capitalization and yield rates provide the backbone of analysis in more detail in later posts.

All real estate investors, in one way or another, must incorporate the following four steps in their fundamental analysis & decision making process.

1. ESTIMATE THE STREAM OF EXPECTED BENEFITS.

Expected benefits include cash in the form of rent, depreciation, possible tax savings on other income, proceeds from the sale of the property (reversion), as well as other ancillary benefits. Make sure you project yearly changes in potential gross income, expenses, vacancies, capital growth and taxes using either a reconstructed operating statement or a pro-forma.

2. ADJUST FOR THE TIMING OF THESE BENEFITS.

$1000 received today is worth much more than $1000 received 10 years from now. Adjust for the timing of these benefits by using a process called discounting. If your time horizon is 10 years and you have purchased property solely for capital growth, then you had better be highly confident that the return you will receive through appreciation will be worth the wait and exposure to increased solvency risk.

3. ADJUST FOR DIFFERENCES IN PERCEIVED RISKS.

Real Estate is exposed to various forms of risk from issues in liquidity, interest rates, inflation, and economic growth, among others. However, Discounted Cash Flow models, sensitivity analysis, and simulation can give investors a handle on probable ranges in which an investment might fall in forms of risk management.

4. RANK ALTERNATIVES.

Different properties (or investments) should be ranked on perceived risk-return combinations. Additional financial returns should be rewarded for any added risk undertaken. Net Present Value can give us an indication of the total return of an investment in absolute terms while use of a Profitability Index can help analyst rank investments that differ greatly in overall cost and value.

About Author

Anwell Tsai, a Realtor for Real Estate One, grew up in the Real Estate business. Anwell is extremely interested in analyzing property from a variety of viewpoints, utilizing different financial models. He explores various issues in Real Estate on his blog at ValuationHome.com. When he is not out looking at homes, Anwell, a conservatory trained violinist, loves expressing his creative side through the joys of music.

6 Comments

  1. Hi Anwell,

    Very good blog info. Are you a financial planner ….In some good finance sites I have seen such good tips on mortgages and other finance topic.

    Really great post.

    Regards
    Ashley

  2. Psychic and Ashley,
    Thanks so much for your kind words. I’m not a financial planner but I love analyzing different types of investment. Ashely, I would be very interested in visiting some of the finance sites you recommend. Which sites do you recommend?

    • Hi Anwell,

      I will show you all the sites. Please mail me. I was checking the comments today so got your reply and replied. Please mail me. I hope you have my e-mail adress.

      Regards,
      Ashley

  3. Great to see the broad concepts presented here. Would love to see more details in terms of how to conduct this type of fundamental analyses with some specific examples in your future posts.

  4. Net Present Value can give us an indication of the total return of an investment in absolute terms while use of a Profitability Index can help analyst rank investments that differ greatly in overall cost and value.

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