Have you ever wondered what a Pro-Forma or a Cap Rate is? Are you trying to figure out what NOI means? Do you want to know how to calculate the various types of ROI, like Cash-on-Cash Return and Total Return?
If yes, then read on…
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We get a lot of posts on the BiggerPockets forums asking about evaluating deals — everything from single family homes to large apartment complexes. Oftentimes, the posters and the readers of the posts have a reasonable understanding of the basic building blocks of a financial analysis, but all-too-often, I find myself (and others) reiterating some basic concepts around deal analysis.
While I love answering questions, I figured it would be easier to document the basic financial analysis process in one place, so that in the future, I can just refer readers here when they have basic questions. Below is a primer that I put together a couple years ago while I was learning the process of financial analysis; while this should by no means be considered a comprehensive review of the subject, it should serve as a good introduction for most readers.
So, without further ado, let’s jump in…
(Oh yeah – hey you! To accompany this blog post, I created a free PDF poster you can download right now and print out. It’s called “The 10 Biggest Mistakes Investors Make When Analyzing Rental Properties” and will help you avoid the mistakes that so many investors make when analyzing deals. Don’t buy a bad deal! Avoid these 10 mistakes and get a great investment property! To get the PDF, just click the button below:)
How to Invest in Real Estate While Working a Full-Time Job
Many investors think that they need to quit their job to get started in real estate. Not true! Many investors successfully build large portfolios over the years while enjoying the stability of their full-time job. If that’s something you are interested in, then this investor’s story of how he built a real estate business while keeping his 9-5 might be helpful.
Have you ever considered buying investment real estate? Are you curious about how you would go about analyzing the financial details of the property you are considering buying? How you would go about figuring out if the property were a good deal or rip-off? The following is a detailed tutorial on how to do a thorough financial analysis of any multi-unit residential rental property you might be considering purchasing.
While different sized properties require more or less analysis then you’ll find here, the information presented in this document is the basis for analyzing any sized multi-unit residential property, from two-unit duplexes to 500-unit apartment complexes. While this analysis will certainly work for single-family rentals (in fact, this type of analysis will work for most investments, in general), the market value of single family homes is generally determined differently than multi-family properties.
The value of single family homes (investment or not) is generally determined by market “comps.” Comps (or “comparables”) are those properties in the same area that have similar characteristics – same floorplan, same number of bedrooms/bathrooms, equivalent garage size, same amenities, etc. So, a single family investment home will generally rise in value if similar homes in the same area are rising in value, and lose value if similar homes in the area are losing value.
Larger investment properties (those with at least two units, and especially those over four units) are priced/valued differently. The value of larger investment properties is directly related to how much income/profit it produces for its owner. So, it’s possible that an apartment building in a neighborhood where house prices are dropping could be increasing in value — especially if the components of the market that drive income are improving. The fact that multi-family properties are valued based on their income potential demonstrates how important good financial analysis of these properties is.
You can’t just compare your apartment building to others down the street to see how much it’s worth. I should also mention that, while this analysis will work for any multi-unit residential rental property, it is not sufficient for analyzing all types of commercial property; for things like office, industrial, or retail space, there’s a lot more you need to know, and I would recommend you find some additional resources. The goal is this document is to teach even the most novice real estate investor how to analyze the financial components of a rental property, but I expect more experienced investors will also find some good information in here.
GATHERING YOUR INFORMATION
The first step in being able to analyze the value of a rental property is to understand what factors contribute to property value. In general, good financial analysis involves being able to input a bunch of information about your real estate investment into a financial model, and have that model kick out a bunch of information that you can then use to determine whether the investment is a good or a bad one (and whether it is the right investment for you). Below are the very high level inputs necessary to perform a thorough financial analysis of a residential rental property:
- Property Details: This is information about the physical design of the property, including number of units, square footage, utility metering design, etc
- Purchase Information: This is basic cost information about the property you are considering, such as the purchase price, the price of any rehab or improvement work you’ll need to do, etc
- Financing Details: These are the details of the loan you will obtain to finance the property. This includes such things as total loan amount, downpayment amount, interest rate, closing costs, etc
- Income: This the detailed information about the income the property produces, such as rent payments
- Expenses: This is the detailed information about costs of maintaining the property, including such things as property taxes, insurance, maintenance, etc
Getting good data out of your model requires that the information you put into your model is highly reliable and accurate; gathering accurate data can often prove the difference between making the property look great on paper and look horrible.
Pro-Forma vs Actual Data
Remember from the introduction of this tutorial that the value of multi-unit properties is directly related to how much income/profit it produces for its owner. Because of this, it’s often in the seller’s best interest to provide numbers that are more “appealing” than they are accurate; for example, a seller may give high estimates of rental income or neglect to mention certain maintenance expenses to give the impression that the property is more valuable than it is. So, part of your job is to make sure you have the best information available when doing your financial analysis.
How do you do that, you might ask? Well, while you may rely on “pro-forma” data (basically, pro-forma means “estimated”) from the seller to kick off a discussion about a property, you should ensure that before you actually close on the property that you get actual data about income and expenses. You should ask to see previous years tax returns, property tax bills, maintenance records, etc. Hopefully all the actuals will prove similar to the pro-forma data you had previously been given, but don’t be surprised if it doesn’t. Remember, the seller is trying to make a sale, and will oftentimes get creative to make the numbers seem better than they are.
In addition to getting actual data from the seller, you should do your best to ensure there are no surprises if you were to buy the place. For example, when was the last time the property was assessed for taxes? If it was a while ago, and values have increased significantly since then, it’s possible that the property will be reassessed very soon, and property taxes will increase. Remember, even small changes to the income and expense numbers can mean big changes in your bottom line.
Where to find your data
In terms of the input data we discussed above, here is where you should be looking for each of these:
- Property Details: This information should be available from the seller, but more comprehensive and detailed information can also be obtained from your local County Records Office
- Purchase Information: Obviously the seller is going to name a purchase price (which will likely be negotiable, of course), but the more important information here will be any upfront maintenance or improvement work that needs to be completed to ensure that the property can (or continue to) meet its income potential. While there may be no extra cost here for properties in good condition, it’s worth having the property inspected by a professional building inspector to ensure that there are no hidden issues or problems
- Financing Details: You’ll want to talk to your lender or mortgage broker to get an idea (or better yet a letter of approval) about the cost of the loan and the necessary downpayment
- Income: Details about income should come directly from the seller, but as mentioned above, don’t rely on pro-forma data for final analysis. You can also talk to the property management company currently running the property (if there is one) to get this information
- Expenses: Similar to income, details about expenses should come directly from the seller (last warning not to trust pro-forma data!) or the property management company currently running the property. This is another place where a building inspector could help warn you about any major repairs that may be coming due in the near future (new roof, new heating/AC, etc)
While it will be your responsibility to do your own due diligence in gathering the necessary data when it comes to evaluating real properties, I’m going to take the liberty to create a fictitious apartment building for sale to use as an example for this tutorial. Here are the high-level details on the building (click here to download flyer)… For reference, this is similar to what a seller might provide in terms of pro-forma data on a property for sale (though a good seller would hopefully have something a little more professional looking).
The flyer above contains most of the data you’ll need for this analysis (though again, remember that this is just pro-forma data; you’ll want actual data before signing any contracts). The one thing the the seller can’t tell you is what your financing will look like for your property; that’s something you’ll need to determine with your lender or mortgage broker. For the sake of this example, let’s assume we’ve also spoken with our lender, and have secured a loan with the following properties:
- Price: As listed in the flyer
- Improvements: $10,000, as listed in the flyer
- Finance Amount: 80% of total cost
- Interest Rate: Fixed 7% over 30 years
- Closing costs: 2% of total property cost
Based on that here are the calculations we’ll need later in our analysis: Now, using this fictitious building and our assumed financing options, let’s jump into our analysis!
NET OPERATING INCOME (NOI)
It’s now time to jump into the analysis. And one of the cornerstone metrics of RE financial analysis is “Net Operating Income” or “NOI.” In short, NOI is the total income the property generates (after all expenses), not including debt service costs (loan costs). In mathematical terms, NOI is equivalent to the total income of the property minus the total expenses of the property: NOI = Income – Expenses In general, NOI is calculated on a monthly basis using monthly income and expense data, and can then be converted to annual data simply by multiplying by 12. So, now that we know we need NOI, and we know that NOI is calculated using property income and expenses, let’s jump into our income and expense calculations.
Assessing Property Income
Gross income is the total income generated from the property, including tenant rent, other income from such things as laundry facilities, parking fees, etc, and any other income that your property will produce on a regular basis. From our example property, we have 8 units renting for between $525-650 per month, as follows: Plus, we have $200 per month ($2400 per year) in additional income from laundry facilities in the building, for a total monthly income of $4700 (and annual income of $54,000). Because the majority of a property’s income generally derives from tenant rent, it is very important that your income calculations take into account the rent you won’t be collecting due to unit vacancy. In any area, there is some average vacancy rate; the vacancy rate for the property you are evaluating may be higher or lower than the surrounding area, and if it is, you need to decide how you’d like to factor that into your analysis. For example, if building vacancy is listed as lower than average local vacancy, the first question you should ask is whether the data you are looking at is pro-forma or actual? If it’s actual, what is the current management doing to keep the building filled? Is the rent lower than market rents? When do current leases expire? In any regard, you need to determine what you think is a reasonable vacancy rate going forward; my suggestion would be to err on the side of conservative for this, and not assume that your vacancy rate will be any lower than the local average vacancy rate. So, to assess total income on the property, you want to subtract out the income that you likely won’t see due to vacancy. In our example property, only 7 of the 8 units are listed as vacant (which equates to about 12% vacancy), so we’ll go with that for our analysis. So, our total monthly income for this property would be: With the total monthly income $4160, the total annual income would be $49,920.
Now let’s calculate our total expenses for this property. In general, expenses break down into the following items:
- Property Taxes
- Maintenance (estimated based on age and condition of property)
- Management (if you choose to employ a professional property manager)
- Advertising (to advertise for tenants)
- Landscaping (if you hire a professional landscaping company)
- Utilities (if any portion of the utilities is paid by the owner)
- Other (anything else we may have missed above)
Any expenses listed as monthly should be converted to annual, and then we can total our expenses to find the annual cost of operating the property: So, the total annual expenses for this property would be $12,751.
Now that we have our total annual income and expenses for the property, we can calculate NOI using the formula above: NOI = Income – Expenses = $49,920 – $12,751 = $37,169 (the property generates $37,169 per year) While NOI doesn’t give you the whole picture (or even enough information to make any decisions), it is the basis for calculating most of the important metrics in our analysis. In the next section, we’ll examine those key metrics…
Common RE Performance Measurements
We now have all the key pieces of information necessary to determine if this property meets the financial bar you’ve set for making an investment. If you remember from the beginning of this tutorial, I listed a number of key outputs you will want from this analysis. In this section, I will focus on the first two of these – Cash Flow and Rates of Return. In the last section, we learned that NOI was the total income the property produced, not including the debt service (loan) costs. You might have been wondering, “Why doesn’t NOI include the expense cost of the loan, since that will ultimately affect your bottom line?”
The reason we don’t include debt service in the NOI calculation is that NOI dictates what level of income the property will produce independent of the owner’s particular financing model. Because the monthly or annual debt service amount is going to be specific to the particular financing plan (it will be dependent on the downpayment amount/percentage, interest rate, amortization schedule, etc), if we included debt service in the NOI, then NOI would only be meaningful in the context of that particular financing plan. And because different buyers will no doubt have different financing, it’s important to have an income metric that is specific to the property, not the buyer.
That is why we have the cash flow calculation. Cash flow is equivalent to NOI adjusted for the expense of debt service. Specifically, cash flow is the NOI minus the debt service payments: Cash Flow = NOI – Debt Service As might now be obvious, cash flow is the total profit you will see at the end of the year from this property. As is also probably obvious, the higher your debt service payments (the larger your loan, higher your interest rate, or shorter your amortization period), the smaller your cash flow. If you pay all cash for a property (don’t take any loan), your cash flow will equal the NOI – this is the maximum cash flow on the property.
If you recall from our financing data, our monthly debt service would be $2129 on this property, and therefore our annual debt service would be $25,548. For this property, our cash flow would be: Cash Flow = NOI – Debt Services = $37,169 – $25,548 = $11,621 (at the end of the year, we’d have $11,621 in our pocket from this property) Hmmm, paying all cash will minimize my debt service (it would be $0) which would therefore maximize my Cash Flow. So, if paying all cash maximizes Cash Flow, and if you have the means to pay all cash for the property, why wouldn’t you? Read on to find out…
Rates of Return
Cash flow isn’t the only important factor when it comes to analyzing the property. What is more important than cash flow is rate of return (also known as return on investment or ROI). Think of ROI as the amount of cash flow you receive relative to the amount of money the investment cost you (your “basis”). Mathematically, that would be: ROI = Cash Flow / Investment Basis Obviously, ROI is going to be higher when one or both of the following is true: Cash Flow is higher or Investment Basis is lower. You can see that from the equation above, but it should also be obvious when you think about it: if you can make a lot of money from a small investment, things are good!
What is a reasonable ROI, you might ask. Well, we already know our ROI from several other types of investing vehicles. For example, if you put your money in a high-interest savings account, your return (in this case, your interest rate) is about 5%. In mathematical terms, for every $100 you “invest” in your savings account, you get $4 in cash at the end of the year: ROI = Cash Flow / Investment Basis = $4 / $100 = 4% We know that a savings account will have an ROI of about 4%. A CD will have an ROI of about 5%. And if you do a little research, you’ll find that investing in the stock market will have an average ROI of about 8-10%. So, what would our ROI be on this property? There are actually three ROI numbers that you should be concerned with; let’s explore each of these individually.
Capitalization Rate (Cap Rate)
Just like we have a key income value (NOI) that is completely independent of the details of the financing, we also have a key ROI value that is also independent of the buyer and the details of the financing. This value is known as the “Capitalization Rate,” or “Cap Rate.” Cap Rate is calculated as follows: Cap Rate = NOI / Property Price If there is a single number that is most important when doing a financial analysis of a rental property, the Cap Rate may be it. Because the Cap Rate is independent of the buyer and the financing, it is the most pure indication of the return a property will generate.
Here is the cap rate for our example property: Cap Rate = NOI / Property Price = $37,169 / $418,000 = 8.89% Another way to think about Cap Rate is that it is the ROI you would receive if you paid all-cash for a property. Though, unlike cash flow, where the value is maximized by paying all cash, the Cap Rate is *not* necessarily the highest return you’ll get on a property. This is because Cap Rate assumes that the investment amount is the maximum (the full price of the property), and we learned above that the value of ROI calculations goes up as the investment amount goes down.
So, what is a good Cap Rate? It really depends on the area of the country you’re in, but in general, most areas see maximum Cap Rates in the 8-12% range. And just like the value of single family houses are based on the prices of comparable houses in the area, the value of larger investment properties are usually based on the Cap Rate of comparable investment properties in the area. So, if the average Cap Rate in your area is 10%, you should be looking for at least an 10% Cap Rate for your property (barring other more complex situations and considerations).
Cash-on-Cash Return (COC)
Just like there are multiple measures of income – NOI (financing independent income) and Cash Flow (financing dependent income) – there are also multiple measures of return. As we’ve discussed, the financing independent rate of return (the theoretical return on a fully paid property) is the Cap Rate, and of course there is the real (not theoretical) rate of return as well. This is called the Cash-on-Cash (COC) return, because it is directly related to the amount of cash you put down on the investment.
For example, we discussed that if you took $100 and put it in a savings account, you’d receive $4 per year, or 4% ROI. The COC is the equivalent measure of how much return you would make if you put that $100 into the property. COC is calculated as follows: COC = Cash Flow / Investment Basis In our example, the annual Cash Flow was $11,621, and the investment of cash that we had to apply upfront on the property was $98,000 (this includes the downpayment, the improvements, and the closing costs). So, our COC is: COC = Cash Flow / Investment Basis = $11,621 / $98,000 = 11.86% As this return is directly comparable to our savings account return, we can see that we are getting a better return than either a savings account or in a diversified stock portfolio (albeit with a lot more time and energy spent).
While it’s completely up to you on what rate of return you need to purchase a property, it should be obvious that if you’re getting less than a 10% return on a property, it’s probably not worth your investment (you’d rather take that money and invest in the stock market where you can do a lot less work). But, before you run off and make any final decisions based on COC, consider that the Cash Flow you make on a property isn’t the only thing that affects your bottom line…
In addition to Cash Flow, there are several other key financial considerations that affect a property’s performance. Specifically:
- Tax Consequences (depending on your situation, you may gain or lose money to taxes)
- Property Appreciation (you may not be able to predict this, but if you can)
- Equity Accrued (remember that your tenants are paying off your property for you)
The difference between COC and Total ROI is that COC only considers the financial impact of Cash Flow on your return, while Total ROI considers all the factors that affect your bottom line. Total ROI is calculated as follows: Total ROI = Total Return / Investment Basis, where “Total Return” is made up of the components we discussed (Cash Flow, Equity Accrual, Appreciation, Taxes). Let’s use the following for our Total Return calculation:
- Let’s assume we would expect a 2% appreciation on the value of the property this year, based on the improvements that we would do upon purchase (2% appreciation is $8360)
- We can calculate that the equity accrued in the first year of the mortgage is $3251
- Let’s also assume that for the sake of this example that there are no tax breaks (or extra taxes due) by owning this property.
The Total Return of the property for this year would be: Total Return = $11621 + $8360 + $3251 + $0 = $23,232 And, therefore the Total ROI would be: Total ROI = Total Return / Investment Basis = $23,232 / $98,000 = 23.71% Not too shabby, huh?
Financial Analysis Summary
We now have all the data to assess the value of this property, but keep in mind that our assessment is only for the first year of ownership of this property. In subsequent years, accrued annual equity will increase, expenses may rise (with inflation), rental rates may increase or decrease, depending on the market, your tax situation may change, and a host of other factors may contribute to the return on you investment either increasing or decreasing.
While you can’t predict the future, you should extend your analysis out a couple years, using trend data or demographic data that indicates the direction of the market, inflation, etc. For example, here is a full financial analysis of this particular property, using a spreadsheet I’ve put together to easily create a financial model for any property. As you can see, based on the assumptions that revenue will rise 3% per year (rental rates will increase) and operating expenses will increase 2% per year (inflation, cost of services, etc), our cash flow (and our rates of return) are increasing each year as well. An even more thorough analysis would take into account things like taxation issues, where with the tax deductions you’ll likely receive on the interest portion of your loan, your return may be even better.
(Oh yeah – hey you! To accompany this blog post, I created a free PDF poster you can download right now and print out. It’s called “The 10 Biggest Mistakes Investors Make When Analyzing Rental Properties” and will help you avoid the mistakes that so many investors make when analyzing deals. Don’t buy a bad deal! Avoid these 10 mistakes and get a great investment property! To get the PDF, just click the button below:) Click Here to Get the Free PDF Poster!