Real Estate Investment Evaluation is Both Quantitative and Qualitative
I was taking a look at a potential investment the other day. It was a sprawling four unit multi-family property that was being occupied in its entirety the owner, who had been there for thirty years. The owner was an eclectic academic and there was every manner of bric-a-brac and antique scattered throughout the place. The place wasn’t sub-divided properly. Carpet needed to be replaced and floors repaired. The shifting foundation had bulged the floor in places, and had created large cracks that ran up and down various walls.
I toured the place with some friends of mine – a couple that was interested in getting into real estate. They wrote the place off from the moment they walked in the door. But when I saw those bulges and cracks I saw one thing: money. Foundation problems scare off most investors, which decreases competition and can soften up pricing.
But how to evaluate a deal like this? Or any deal, for that matter? Personally, I break the considerations down into two categories:
- Quantitative: How do I expect the property to perform as an investment? For this part I can whip out my calculator, or my spreadsheet, or my evaluation software and run some numbers.
- Qualitative: I have to ask myself “can I pull it off?” If you’re like the vast majority of real estate investors, then you’re a part-timer. That means you’re going to have to tackle this project on top of your “day job” and manage it afterwards. This part of the analysis will take some soul searching; a calculator isn’t going to help you here.
Quantitative – Running the Numbers Using Cap Rate
Personally, I tend to look at three key figures when I’m considering an investment. Cap rate, is the first of these tools.
Cap rate is simply the annual net income divided by the price of the property. For years investors have been using the “1% rule” which simply states that the monthly rental income for a property should be roughly 1% of the price that you pay for the property. Some markets have moved away from this ratio due to rocketing property values, but in others you can still find properties that fit the 1% rule. Something that you should keep in mind, though, is that the 1% rule of thumb is a fair indicator of whether or not the property is going to generate enough cashflow on an annual basis to cover mortgage payments plus expenses. There, of course, are a lot of variables that go into this (from taxes, to interest rates to the percent down payment that you pay) but it’s a starting point.
Cash Flow as a Quantitative Evaluation Tool
The only reason you care about cap rate is that you’re really trying for an easy proxy for what kind of cashflow the investment is going to generate. In investing cash is king – ignore this calculation at your peril.
Estimating cashflow entails plotting out the major expected cash outflows (taxes, principal, interest, expenses, vacancies, fees, repairs) and comparing it with the income that the property produces. You can do this either via a spreadsheet or using a real estate evaluation software package.
Rate of Return as a Quantitative Real Estate Investment Analysis Tool
Cashflow, in turn, will allow you to calculate the property’s expected rate of return (ROR). Rate of return is a measure of profitability; it measures the cash that a project will generate vs. the cash that you have to put into the project.
You’ll need a spreadsheet or a real estate evaluation software to calculate this ratio. I think it’s highly useful because it allows me to compare the return I’m expecting for the investment vs. the return I would reasonably expect for other, dissimilar investments.
For example: if I ran the numbers for the property I described at the beginning of this article and it kicked back to me a rate of return of 8% I’d surely pass.
I can expect to get 8% investing on the stock market (lower risk, and a whole lot less effort). For the risk and effort I’d have to put into this project I’d expect a rate of return well north of 20%.
Qualitative – Can You Get the Project Done?
As I mentioned above, your calculator won’t help here. This is when you need to take a look in the mirror and think about how much time and effort you’re going to be able to devote to the project.
Again, let’s look at the project I talked about at the start of this article. Let’s say you’re comparing it against a similar opportunity; another multi-family in the same neighborhood but which requires less work. You’d take that opportunity over the fixer-upper unless the second one offered a considerably higher rate of return. But how much higher?
To starting investors I always offer the same advice: In this area err on the side of caution. A project that you can get done is infinitely better than one that has you burned out by the time you’re halfway through it. Find something in your comfort range that offers some decent numbers, get it done, then move on to a more challenging (and hopefully more profitable) project the next time around.
Analysis is part art, part science. Take a look at the other topics in this section for more ideas on evaluating investments.