How to Analyze a Rental Property to Maximize Your Returns
Posted by Grant Cardone
To build wealth in real estate, you have to be able to pick the right investments. We’ll show you how here.
An important skill for real estate investors to have is the ability to properly analyze a potential investment.
As with any type of investment, you need to make sure you receive a return on the money you invest. The return you receive should be related to the amount of work the investment requires and the amount of risk involved.
The expected return will also vary with different property types and geographic locations.
This guide will teach you how to effectively analyze a property before a purchase is made, so you can make smart investments.
- The different types of income properties
- Valuation methods
- How to analyze a property
Different Types of Property, Different Methods of Valuation
The method of determining a property’s value depends on the type of property you’re looking at:
1. Single-family rentals
These properties’ values are based mainly on comparable sales of other single-family homes – regardless of their expected return on investment. While a professional appraiser will consider the income of a rental property, they have to consider what it would sell for without rental income.
Government regulations set standards for residential appraisals in order to protect financial institutions and borrowers.
It’s also important to note that single-family property values change with the local housing market, which can affect your overall return on investment.
Before purchasing a single-family home as a rental property, it’s still important to do an investment analysis. This will help determine if the income is worth the purchase price and if the monthly rent can cover the loan payments and expenses.
2. Multifamily properties
For the most part, these properties’ values are based on their current income or income potential. Since multifamily properties aren't considered residential property, valuation standards weigh more heavily on their value as an investment.
The values change based on generated profit and the market’s expectation of rate of return. As the demand for multifamily properties increases, investors are willing to accept a lower rate of return, which drives the value up.
3. Commercial properties
Similar to how single-family homes are valued, single-tenant and owner-occupied commercial properties are often valued based on comparable property sales. Some single-tenant properties are valued based on income, depending on:
- The tenant – national tenants with strong credit will provide a higher value
- The remaining term of the lease – properties with long-term leases in place will provide a higher value
Leases close to expiration and short-term leases are high risk because the sole income generator may be leaving soon.
Multi-tenant commercial properties are valued based on both current income and income potential. This is assuming that the property currently has tenants in place.
Property values also depend on the tenant mix, the tenants’ credit, and the length of time left on their current lease terms.
Successful investors typically use a variety of methods to determine a property’s value.
Some valuation methods are simple rules of thumb. These methods are used to quickly run the numbers to gauge whether a property looks like a good deal and is worth analyzing further. Others are more precise, requiring mathematical formulas.
The more complex methods are normally done during the due diligence period to make sure the property is a good investment.
Study your local market to find out:
- What types of valuations are commonly used for properties in the area
- The expected rate of return for different property types
Process of analyzing a rental property
Taking these steps will ensure an accurate analysis of an investment property.
Gather information on the property
In order to analyze a property, you must gather property information, such as:
Public Records/Tax Records
These will often show the square footage, the year built, zoning, and what the property was most recently sold and purchased for
This includes rental income and other property income such as laundry, pet fees, etc
The property expenses include all the things you have to pay for in order for your investment to keep producing income. These are very important pieces in understanding a real estate investment’s financial picture.
- Property taxes
- Property insurance
- Management fees
- Vacancy rate
- Repairs and maintenance
Capital Expenditures (CAPEX) / Deferred Maintenance
All properties will occasionally have major expenses, such as acquiring, maintaining or improving:
- Driveways and parking lots
These should be included in a monthly budget to avoid major expenses when potential property repairs or maintenance are needed.
Calculate net operating income (NOI)
You also need to determine the property’s net operating income (NOI).
This is the annual profit before mortgage payments and income taxes. In order to determine NOI, you must:
- Calculate total annual gross income from property rents and other income
- Calculate total annual operating expenses
Major one-time costs can be removed (or, in investment language, “added back” to the profit) from the total expenses if they won’t be an ongoing expense.
- Calculate estimated capital expenditures budget
- Subtract annual operating expenses and CAPEX from the total annual gross income:
Gross Income – Operating Expenses – CAPEX = Net Operating Income (NOI)
Here is an example of an apartment building’s financial statement, where you can see the property’s NOI.
Find the capitalization rate
The capitalization rate (often just called cap rate) is a basic method used to analyze and evaluate properties.
It calculates what percentage of the property’s purchase price is returned each year in the NOI.
The calculation doesn’t take into account any mortgage payments made on the property.
Net Operating Income / Purchase Price = Capitalization Rate
Using the example financial statement above, here is the calculation of the cap rate.
$688,651 / $10,000,000 = 6.9%
In order to use the cap rate method effectively, you’ll first need a target cap rate. Studying local markets will show you at what cap rate similar properties are selling for.
Net Operating Income / Desired Cap Rate = Property Value
Using the example statement with a desired cap rate of 6.5%, here’s the calculation of the property value:
$688,651 / 6.5% = $10,594,630
Calculate the cash-on-cash return
This is a calculation that determines the cash income earned on the cash invested in a property (the total out-of-pocket expenses). These expenses include down payment on a loan and cash used for property rehab and/or repairs.
This rate of return is calculated on the free cash flow – or, the cash flow after mortgage payments are made.
NOI – Principal and Interest Payments (P&I) = Free Cash Flow
Using the example financial statement, here’s the loan payment estimate:
Purchase price: $10,000.000
20% down payment: $2,000,000
Amortization: 20 years
Interest rate: 4.5%
Monthly P&I: $40,534
Annual debt service: $486,418
Here’s the calculation to determine free cash flow:
$688,651 (NOI) - $486,614 (Annual Debt Service) = $202,233 (Free Cash Flow)
Finally, to calculate the cash-on-cash return, use this formula:
Free cash flow / total cash into the deal = cash-on-cash return
Here it is, using our example numbers:
$202,233 / $2,000,000 (20% down payment) = 10.1%
In most cases, the lower the down payment needed, the higher the cash-on-cash return will be.
Determine the projected equity multiple
The total return on investment is calculated using the cash-on-cash return plus the equity built over time with rental income.
As the NOI is used to cover the debt service, equity is being built in the property. When it’s time to sell the property, the investor will receive the increased equity as additional profit.
In our example, let's see what the equity would be if the investor kept the property for 10 years before selling it. We're just going to assume that the property never appreciated in value and rents never increased (but in reality, they would).
Original equity: $2,000,000
Original loan amount: $8,000,000
Total principal paid: $1,592,845
Total equity: $3,592,845
Equity multiple: 1.8x
This means you got 1.8x the cash you put into the deal back, just in equity. That’s an annualized return of almost 8%.
To properly estimate the equity multiple, you’ll have to figure out what you anticipate the rental income to be each year over the next 10 years and use the average inflation rate to estimate expenses. This way you can project what the NOI will be in 10 years and estimate what the value will be at that time.
Now let’s look at the total return you would receive on your investment over 10 years.
$202,233 (Free Cash Flow) x 10 years = $2,022,330 (Total Free Cash Flow)
Then, use total free cash flow to calculate equity:
$2,022,330 (Total Free Cash Flow) + $1,592,845 (Equity in Property) = $3,615,175
This gives you an annualized return of almost 18%
By understanding how to analyze rental properties using different methods, you can be confident that you're making the right investment decisions and are able to spot a great deal. It's always a good idea to run it by another experienced investor to get another perspective and to make sure you didn't miss anything.
Cardone Capital has some of the most well-educated and experienced real estate analysts in the industry. The team is constantly reviewing multi-family investment properties to look for the absolute best opportunities available.
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