Investing in real estate is a great way to earn income and create long-term wealth. However, it’s crucial to understand the key factors of analyzing an investment property to maximize your investment’s potential. After all, investing in real estate is a significant financial decision, and you must be wise to be successful. Today we will we discuss how to analyze investment properties and the importance of property value.
What is an Investment Property Analysis?
An investment property analysis is how real estate investors summarize the performance of their rental properties. Typically, an analysis will look at an investor’s current holdings from their rental investments along with ratios of income and expenses.
An investment property analysis is vital because it gives investors an idea of what’s working and what’s not within their rental business. Additionally, it offers investors a chance to adjust and improve their business to attain higher returns.
How Do Rental Properties Make You Money?
There are many ways for investors to make money on rental properties. That said, every property is analyzed and valued differently. For example, single-family homes and multi-unit properties use different metrics to evaluate an investment’s viability. Check out some of the differences between the two.
Single-family homes are compared and valued similarly to nearby properties with similar features. For example, when you value a single-family property, you’ll look at other single-family homes with the same number of bedrooms, floorplan, bathrooms, and amenities. As such, when a single-family home rises in value, a similar home will also increase in value.
Properties that are larger with multiple units are valued differently than a single-family home. That said, the value of these properties is determined by how much income the property produces. Unlike single-family investments, you can’t compare one multi-unit property with another to decide how much it’s worth.
The truth is, there are tons of factors to consider when calculating the value of a multi-unit property. Cash flow and appreciation are two of the most important. Later, we will discuss these two factors in more detail and see how they play a part in analyzing an investment property.
Gathering All the Relevant Information
When you analyze investment properties, the first step is gathering the correct information. Some of the factors you’ll want to consider include:
- The details of your property or properties, including the number of units, square footage, home designs, etc
- Total purchase expenses for your investment properties
- Mortgage payments and loan information
- Income and expenses, including total profits and money spent on a property
Typically, you can find this information by contacting your Washington DC property managers and your lender or mortgage broker. Next, let’s go over some of the critical elements to consider when analyzing investment properties.
Elements of a Rental Investment Analysis
Most of the important elements of a property analysis involve careful compiling and calculation of numbers. For example, you’ll want to find out the net operating income, property income, and total expenses for each property. Let’s go over how you can find these numbers.
Net Operating Income
The net operating income, or NOI, is one of the most crucial factors in analyzing any investment property. This metric refers to the total income of a property after all expenses are taken out.
To calculate NOI, first take the income and subtract your expenses. Investors can generally find this number by using monthly income and expense data, then multiplying that number by 12.
- Example: NOI = Income – Expenses
However, it’s important to keep in mind that this number is not as accurate as determining your property’s cash flow. The net operating income does not generally include your debt service. The reason for this is that the NOI simply determines how much the property produces minus the owner’s financing.
Before you can accurately find your property’s NOI, you need to determine the property’s gross income. The gross income includes all the property’s income, including tenant rent payments, parking fees, utilities, and more.
Typically, the vast majority of a property’s gross income comes from tenant payments. Because of this, it’s important to account for vacancies. So, when you are calculating your property’s income, you must account for potential vacancies by subtracting the income you’ll miss out on.
Next, you have to add up the expenses for your properties. Generally, property expenses include the following:
- Mortgage interest
- Property management fees
Factors to Consider When You Analyze Investment Properties
- Cash Flow
- Rate of Return
- Capitalization Rate
The largest part of analyzing an investment property is examining the cash flow. The cash flow includes the money left over after paying the bills. In simpler terms, cash flow is:
- Cash flow = Income – Expenses
For example, if a property generates $20,000 per year and you spend $12,000 per year, your annual cash flow would be $8,000.
However, it’s crucial to know that income is more than tenant rent payments and expenses are more than the mortgage. Although these are the main elements, investors must consider other outside factors while determining the property’s cash flow. In addition to the expenses listed above, more considerations include:
- HOA Fees
Rate of Return
The rate of return is another important factor in rental property analysis. The rate of return is also known as return on investment (ROI) or cash-on-cash return. To find this number, you take your property’s cash flow and divide it by the cost of your investment.
- Example: Rate of Return = Cash Flow / Investment Cost
The capitalization rate, also known as the cap rate, determines the returns of the property aside from financing costs. This number is crucial because it’s essential to see the property’s returns independent from financing expenses.
To find the cap rate, take the net operating income and divide it by the total cost of the property.
- Example: Cap Rate = NOI / Property Price
If a property generates a cash flow of $20,000 per year and is worth $250,000, the cap rate would be 8%.
Many investors consider the cap rate to be one of the most important factors since it allows them to see the property’s potential return. Typically, the cap rate is location-dependent since the price of homes is location-dependent. However, the cap rate for investment properties is commonly between 8% and 12%. That said, the higher the cap rate, the better the returns are.
How Do Investors Benefit From Property Management?
Hiring a property management company can help investors in more ways than one. For example, your local property managers can assist with many of the day-to-day maintenance and administrative tasks, so you don’t have to.
Bay Property Management Group proudly serves owners throughout Maryland, Pennsylvania, Northern Virginia, and Washington DC. In addition, we offer full-service rental management for a competitive rate with no hidden fees. If you are interested in learning more about how professional property management services can assist you every step of the way, contact us today for a no-obligation rental home analysis.