Have you ever wondered how to go about analysing a Cap Rate for an investment ? 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 so, no need to struggle alone – I\’ve written what I hope is a handy introduction to real estate investment analysis.
Have you ever considered buying an investment property? Are you curious about how you would go about analysing 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 not? The following is a detailed tutorial on how to do carry out a financial analysis of any residential investment property you might be considering purchasing.
The value of single family homes (investment or not) is generally determined by market rates linked to compatible properties in the surrounding area. These properties have similar characteristics – same floorplan, same number of bedrooms/bathrooms, equivalent garage size, same amenities, etc.
Thanks to this, a single family 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 unitsand especially those over four units) are valued differently. The value of larger investment properties is directly related to how much profit it produces for the owner. It’s therefore entirely 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.
Of course, you can’t just compare your building to others down the street to see how much it’s worth. I should also point out that whilst this analysis will work for a residential rental property, it is not sufficient for analysing 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 searching out additional resources. I may write some in future, but currently have a more limited understanding of that market and don’t feel as comfortable talking about it.
GATHERING YOUR INFORMATION
The first step in being able to analyse 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 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. Below is an overview of the considerations required to perform a thorough financial analysis of a residential rental property:
- Property Details: Information about the physical design of the property, including number of units, square footage, utility design etc.
- Purchase Information: This is basic cost information about the property you are considering, such as the purchase price and the price of any improvement work you’ll need to do.
- Financing Details: These are the details of the loan you will obtain to finance the property. In some circumstances, you may be fortunate to afford the property outright, but most property investors I have met seem to have used significant debt to fund their investments. Consequently, the detail of the total loan amount, structure of the debt, deposit information, interest rates, payment schedules and administration/professional fees all need to be considered.
- Income: This the detailed information about the income the property produces, such as rent payments and funds received from energy generation or car parking rental.
- Expenses: This is the detailed information about costs of maintaining the property, including such things as property taxes, insurance, upkeep and general repairs (yes, you’re going to have to foot the bill every time the boiler break down!).
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.
Estimated vs Actual Data
Remember from the introduction of this tutorial that the value of properties is directly related to how much 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.
Part of your job as an investor is to make sure you have the best information available when doing your financial analysis. You might decide to rely on estimates from the seller as a starting point, but it’s important to carry out your own research about potential income and expenses. Ask to see old bank statements, copies of bills and maintenance records to help verify the information you’re being presented with.
If you’re lucky, these documents will help to support the original information you were presented with, but don’t be surprised if they don’t. The seller is only interested in one thing here – getting the highest price they can for the property and consequently will often feel at liberty to get creative with numbers to help make the deal add up.
In addition to requesting and reviewing documentation, it’s also important to make a careful examination of the property and surrounding area before making an offer. Small problems can often snowball, serious impacting the viability of the investment.
Sources of quality information
When looking for information on the property, requesting information from the seller and/or estate agent is often a good starting point. Make sure to look online, interview neighbours and tenants, review council records and hire relevant professionals such as brokers and surveyors to carry out specialist investigations to support your investment.
Ultimately, it remains your responsibility to carry out sufficient due diligence before purchasing an investment property. I wouldn’t go as far as to advise someone else on whether an investment was suitable for them (indeed, I’m pretty sure I’d be breaking the law if I did!), but there’s nothing stopping me from providing some theoretical illumination on the process by creating a fictitious investment as an example.
Property Value $200,000
Financing: 80% of total cost
Interest Rate: Fixed at 3% over 30 years
Professional Fees: limited to 2% of property value
Based on this information, our investment opportunity stacks up something like this
Property Value: £200,000
Professional Fees: £4,000
Total Cost: £254,000
Cash Expense: £54,000
Loan Value: £160,000
Interest Rate: 3%
Loan Repayment Length: 30 year
Monthly Repayment Value: £250
Now, using this fictitious investment and assumed financing agreement to carry out our analysis!
NET OPERATING INCOME (NOI)
One of the cornerstones of financial analysis is the “Net Operating Income” or NOI. In short, NOI is the total income the property generates after all expenses, not including payments to service debt. In mathematical terms, NOI is equivalent to the total income of the property minus the total expenses of the property:
NOI = Income – Expenses.
NOI is usually calculated on a monthly basis using monthly income and expense data, which can then be converted to annual data by multiplying by 12.
Assessing Property Income
Gross income is the total income generated from the property, including tenant rent and other income from things as energy subsidies, parking fees and any other income that the property generates on a regular basis
From our example property, we have a single property renting for between £525-650 per month. I’m pretty conservative with valuations, so usually take the bottom part of the range and reduce it by another 5%. In this case, that leaves me with a monthly income of £498.75, or a yearly income of £5985. The property generates another £200 a month from a spare parking space, boosting monthly income by £2400 a year, taking annual income to £8385.
Because the majority of the income will be derived from tenant rent, it’s important that we factor in rent lost from vacant periods. Most agents will be able to advise on what this rate is likely to be, but don’t forget to err on the side of caution when determining your expected vacancy rate. To asses total income on the property, I might factor in another eight weeks vacancy on the property, reducing annual income to £7387.50.
Now let’s calculate total expenses for the 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)
I’ve pulled a couple of rough figures out for this section;
Property Management (5% of rent): £299.25
Maintenance costs: £2000
Now that we have our total annual income and expenses for the property, we can calculate NOI using the formula I explained earlier:
NOI = Income – Expenses.
Using the values we just calculated, this gives us £7387.50 -£3649.25 = £3737.75 (meaning that the property generates £3737.75 a year). While NOI doesn’t give you the whole picture, it is our starting point for calculating most of the metrics for more in-depth analysis.
Common Performance Measurements
Now we’ve figured out our NOI, let’s have a look at two other key metrics; cash flow and the rate of return. If the NOI is the total income excluding loan costs, you might be wondering why, as these costs are definitely going to affect the viability of the investment.
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 investor’s financing model. Depending on this model, the debt repayment schedule will vary, and if we included that schedule in the NOI, it would only be valid in the context of that financing arrangement
Because different investors will have different financing models, it’s important to have a metric that’s specific to the property rather than the individual investor.
Of course, is the NOI stacks up favourably, you’ll want to move onto something which takes into account your financing arrangements, which is why we have the Cash Flow metric. Cash Flow for an investment property is essentially just the NOI adjusted to include the cost of debt repayments. Expressed as an equation, it looks like this;
Cash Flow = NOI – Debt Repayments
This output will be the total profit seen at the end of a year from the investment. Following this through, the more you’re borrowing to fund the investment and the higher the interest rate, the smaller your Cash Flow will be. If you buy the property outright, your Cash Flow will be equal to the NOI, which can also be referred to as the Maximum Cash Flow from the property.
If you recall my theoretical financing model, our monthly debt repayments totalled £250 a month and our annual debt repayment would therefore be £3000. For this property, our Cash Flow would therefore be £3737.75 – £3000 = £737.75. That works out a little over £60 a month; not exactly money to retire on.
Hold on though! If you can reduce the debt load by paying more upfront, surely this will improve the Cash Flow metric; that’ll make things more attractive! Actually, as I\’m about to demonstrate, this isn’t a given.
Rates of Return
Cash Flow isn’t the only important factor when it comes to analysing an investment property. Even 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. Mathematically, this is represented as:
ROI = Cash Flow / Investment Value
Obviously, ROI is going to be higher when one or both of the following is true: your Cash Flow is high relative to your initial investment, or your investment is small relative to your Cash Flow. 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 pretty peachy!
So what is a reasonable ROI? Well, a good starting point is your ROI on other investments. For example, you might have a cash ISA paying 1%, a collection of bonds paying 2-4% and a stock portfolio yielding 5%. The cash and bonds are totally secure (although potentially losing money to inflation) and your stock portfolio fluctuates in value (representing potential loss in the event of liquidation), so let’s take a mid-point of 3% where every £100 you ‘invest’ gives you £3 at the end of the year.
Capitalisation Rate (Cap Rate)
Just like we have a key income value (NOI) that is completely independent of the details of a financing model, we also have a key ROI value that is also independent of the investor and details of their financing. This value is known as the “Capitalisation Rate,” or “Cap Rate.”
The 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 their financing, it is the most pure indication of the return a property will generate.
Returning to our fictional property, let’s plug in out numbers;
Cap Rate = NOI / Property Price
£3737.75 / £200,000 = 1.86%
Another way to think about the Cap Rate is that it is the ROI you would receive if you paid entirely in cash for a property. Unlike Cash Flow where the value is maximised by paying entirely in cash, the Cap Rate is not necessarily the highest return you’ll get on a property because it assume that the investment value is the full value of the property and the value of ROI goes up as the investment amount falls.
So what is a reasonable Cap Rate? This is a bit like asking the length of a piece of string – you’ll have to look at returns on other properties in the area and compare the Cap Rate to other investments you could make.
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 bond paying 3%, you’d receive £3 per year, or 3% 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 / Property Value.
In our example, the annual Cash Flow was £737.75 and the investment of cash that we had to pay upfront on the property was £54,000 (this included the deposit, the improvements, and any professional fees). So, our COC is: COC = Cash Flow / Investment Basis = 737 / = 1.36%
As this return is directly comparable to the return available from other investments, we can see that we are getting a worse return than either a bond or our stock portfolio. In addition to this, we have an enormous pot of debt we’re liable for (£160,000 upon purchasing the property), and significant outgoings during periods of non-occupancy.
While it’s completely up to you what rate of return you need to purchase a property, it should be obvious that if you’re getting less 6% return, it’s probably not worth your investment (personally, I’d rather take that money and invest in the stock market where I can do a lot less work to get similar, if not better returns).
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;
- Capital Appreciation (you may not be able to predict this and certainly shouldn’t assume it – but it can help to float a less appealing opportunity)
- 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 / Property Value, where “Total Return” is made up of the components we discussed (Cash Flow, Equity Accrual and Capital Appreciation). Let’s use the following for our Total Return calculation:
- Let’s assume we could expect 1.5% capital appreciation on the value of the property this year, based on the improvements that we would do upon purchase (1.5% capital appreciation is £3000)
- We can calculate that the equity accrued in the first year of the mortgage is another £3000)
Taking these values into account, the Total Return of the property for this year would be: £6737.75 (£737.75 + £3000 + £3000). Therefore the Total ROI would be:
Total ROI = Total Return / Property Value
£6737.75 / £200,000 = 3.37%
Still not fantastic, but better!
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 equity will increase, expenses and rental rates will fluctuate and a whole range of other factors will contribute to the viability of the investment.
While you can’t predict the future, it’s generally prudent to extend your analysis forward a few years, using trend data that indicates the direction of the market and other variables.
These metrics are subject to to variation. Each investor has their preference, but hopefully they\’ll give you a good starting point for carrying out real estate investment analysis.