Despite the recent economic crisis, investing in real estate is still a profitable business. But in order to make a profit, investors have to determine the value of the property or properties that they intend to buy and estimate how much money they will make from their investment.
New investors in real estate might find analyzing a property for investment potential challenging, due to all of the factors that this process involves. Despite the fact that all of these factors seem overwhelming, determining if a property is worth investing in is not that hard. Essentially it is all about the numbers, as analyzing a property involves looking at its income, expenses, and applying a multiplier to determine its value.
The Process of Analyzing a Property
Properties that have good investment potential are the ones which generate positive cash flow and match the investor’s return expectations. Here’s what you should look at before investing in a property:
- Calculate a property’s price based on how many units it has if you are investing in an apartment building, or base the price on its square footage when investing in a commercial property. This, of course, won’t be enough to determine if a property has investment potential, but it will certainly put things into perspective.
- Find out the property’s gross rent multiplier by dividing its price by the annual gross rents that it generates. After you find a property’s GRM, you can compare it to other similar properties in the area. However, properties have different expenses that won’t be reflected in the GRM, so calculating the property’s gross rent multiplier will be only one factor that is involved in analyzing a property’s potential for investment.
- Calculating a property’s net operating income (NOI) is another way in which you can find if the property is worth investing in. The NOI is calculated by subtracting a property’s operating expenses, such as management and accounting fees, maintenance, insurance, utilities and more, from the income generated by rent. The loan payments are not included when calculating the property’s NOI, but you will need to add a management fee and a vacancy factor in some cases.
- The cap rate is the most used way by investors to determine if a property is worth its asking price. The capitalization rate is calculated by dividing the property’s net operating income by its price. You should then compare the cap rate to cap rates for the area that the property is located in to help decide if the property is worth investing in. Generally, the cap rate should be between 7 and 12 percent.
- Another factor that can help you determine if the property is worth the investment is the cash-on-cash return. Cash-on-cash return is calculated by dividing the property’s annual cash flow by the cash that you will invest to acquire the property. Then compare your required return with the property’s cash-on-cash return. If the cash-on-cash return is greater than your required return, then the property may be worth investing in. Otherwise, the property will most likely turn out to be a bad investment.
Analyzing a property for investment potential is much easier than actually finding a property worth investing in. Determining if a property is worth the investment is very important. This will make the difference between you being a good real estate investor and a bad one. This analysis will also influence your profit and for how long you will be able to stay in business. How good an investment is and if it is worth investing in ultimately depends on you, your financial situation and your budget.