Real Estate Investing Analysis

This article gives you a foundational understanding of residential real estate investing analysis, and a formula for determining how much to offer when purchasing property for rehab and wholesale purposes.

Anyone can learn the simple skill of real estate investing analysis. The important point to understand is that the analysis will vary, depending on the type of real estate being discussed. This article focuses exclusively on residential single family and duplex properties purchased for rehab and wholesale purposes.

The first step in your real estate investing analysis is to determine the fair market value of the property after all repairs have been completed. This is done most accurately by having a Realtor run a comparable sales comparison report. Make sure the properties your Realtor chooses are truly comparable, not simply the same bedroom count, but also the same type of construction, in the same neighborhood, roughly the same age, etc..

The next step in performing your real estate investing analysis is to determine the cost of all needed repairs to bring the property into what I call “retail condition”. In other words, how much will all the repairs cost to complete, including materials, labor, and holding costs?

Once you have determined these two values- After Repair Market Value and Repair Costs- the next step in the real estate investing analysis process is some simple subtraction. Subtract the Repair Costs from the After Repair Market Value to arrive at the property’s Current Market Value.

Once you are armed with the Current Market Value of a property, it’s a simple matter to complete the real estate investing analysis and arrive at your offer price. Your offer price will be the Current Market Value minus either $20,000 or 30%, whichever is lower.

To make this real estate investing analysis process all very clear, here’s an example: Suppose you are looking at a single family home in a mid-priced neighborhood. The Realtor pulls Comparables and you determine that the After Repair Value of the property is $150,000. You further estimate that the repairs needed will cost $30,000 to complete, including materials, labor, and holding costs.

Next, as part of your real estate investing analysis, you subtract the $30,000 Repair Costs from the $150,000 After Repair Value, and arrive at a Current Market Value of $120,000. You subtract $20,000 from $120,000 and get $100,000. You also subtract 30% from $120,000 and get $84,000. The lesser of $100,000 or $84,000 is $84,000, so that is your offer price- $84,000.

Using this formula for real estate investing analysis you may miss out on a few properties you could have bought otherwise, but you will never overpay for a property, and you will always make money.

Now, go make more offers!

Why Real Estate Investment Includes Risk Analysis

The bottom line about any real estate investment analysis is that it is a risk analysis. If risk was not an issue with investing, and all the results of any given investment were known with certainty, than creating an analysis for any type of real estate investment would simply be a matter of arithmetic. But the truth about real estate investing is that many factors come into play (i.e., the economy, tenant trends, etc.) that make it impossible to ever know with absolute certainty enough about a typical property to remove every element of the unknown.

Since the ability to accept varying levels of risk will differ from investor to investor, many simply avoid real estate altogether and opt to put their money only in relatively risk-free investments such as government Treasury bills. But the price for this lower level of insecurity, of course, is a lower rate of return. Why, because a relationship always exists between risk and rate of return. Therefore, when investors are attracted to the certainty, they in effect force down the rate of return they are willing to accept as a trade-off for their unwillingness to accept uncertainty.

Okay, so what about the risk takers? What can investors who prefer to collect the higher rates of return associated with real estate investment do to deal with (and perhaps minimize) the ambiguity? Investors must exploit tools that can potentially measure this risk. One method is by applying what is known as a “probability distribution” to prospective real estate investment opportunities.

For example, rather than using just one set of rents to ascertain potential cash flows and returns for a rental property, the investor should consider several rent scenarios that reflect an estimated probability of their occurrence.

In my real estate investment software, for instance, a form is provided that allows users to apply three different rent scenarios to a rental property. This way, rather than just having to accept whatever rents are presented by the seller, the investor can analyze the cash flows and returns based upon a range of rent probabilities (i.e., most likely, somewhat likely, and not likely but “wow, wouldn’t it be great”).

The logic is straightforward. Say, for example, that you’re doing an analysis on a ten-unit apartment complex made up of ten two-bedroom, one-bath units each reportedly with the potential of renting for $700 per month. My own experience warns me that “potential” rents may (or may not) be likely, so I always prefer to run my own rent scenarios. In this case, then, you would use our Rent Scenarios form and assign three rent probabilities based upon your own measurement of risk, and instantly you are the results so you can analyze what impact each rent might have on cash flows, rates of return, and profitability. The outcome if monthly rents are more likely at $650, for instance, could affect your willingness to chance buying the property.

This is only one of a variety of mathematical and statistical approaches to risk analysis that will help you address the uncertainties of real estate investment. But you get the idea. The best way to deal with uncertainty is to measure it. And the probability distribution we illustrated for rents is a good first step.

The Importance of Equity Buildup in Real Estate Investing Deal Analysis

I have a reputation for beginning most conversations about real estate with an easy to remember acronym that describes the many benefits of investing: IDEAL.

Each letter in IDEAL stands for a one of the advantages of investing in real estate: income, depreciation, equity buildup, appreciation and leverage. Actually, I usually add in control as another benefit, but I digress.

While most investors really emphasize income, leverage and appreciation, today I wanted to narrow in and focus on equity buildup.

If you have seen any of my very detailed, deal analysis blog posts (and it is hard to miss them because I analyze deals for over 50 US markets and market the heck out of them), you know that I actually calculate and include the financial benefit of equity buildup.

So, what is equity buildup? Simply, it is paying down the loan on your property. The less you owe the more equity you have (assuming the property value stays the same). So, as you pay down more and more of your loan over time, you build up more and more equity because you have decreased what you owe.

One great thing about the equity that accumulates from paying down your loan is that it is a guaranteed return: if you pay your mortgage payments, you get the return. Plus, your return increases over time. Why? Because you are actually paying down your loan faster and faster with each passing year.

Let me explain: in the first year of a 30 year amortized loan, your payment is mostly interest. In fact, from all of your payments for the entire first year you end up paying off about .9% (less than 1%) of the total loan balance. In the second year, your principal pay-down grows slightly so that you pay off about 1%. In the third year, you end up paying off 1.1% of the loan and each year it increases until, in the last year, you end up paying off about 8% of the original loan amount.

Here’s another way of looking at equity buildup that I personally use. I have a spreadsheet with all my rental properties listed down one side and columns that match each of the benefits from IDEAL listed across the top. I look at the column for equity buildup like I am actually putting that money into a savings account (called equity in my house). With one or two houses it may not seem like that much… a hundred dollars here, a hundred dollars there per month, but get a portfolio of investment property like I have and you’re putting away serious money each and every month. For example, if you had $1,000,000 worth of real estate loans (whether that’s five $200,000 houses or ten $100,000 houses), you could be gaining over $800 per month from equity buildup.

What’s great about this is that, as I mentioned above, this amount grows each year since you end up paying more and more toward principal with each payment. So, the next year you might be saving $850 per month.

It’s kind of like a forced savings plan, because it happens automatically every month that you pay your mortgage, whether you intend to save money or not.

So, when you do your own real estate investing analysis don’t overlook the powerful benefit of equity buildup in your calculations.

How to Create a Real Estate Analysis Without Real Estate Investment Software

If you rather not invest the money into real estate investment software and prefer to create your own real estate analysis, then you certainly can. Rental property cash flow analysis along with rates of return and profitability analysis and marketing presentations can be created by anyone with a spreadsheet program who has the time and patience to do it manually.

First, purchase the spreadsheet program. In this case the obvious choice would be MS Excel for PC users and even for MAC users because MAC does allow you to install and use MS products on your MAC computers. Moreover, MS Excel includes a ton of built-in formulas and features that make it the most-widely used spreadsheet in the world. So you won’t regret having made the investment to purchase it for your real estate analysis.

MS Excel can be purchased alone for around $100 but is regularly included with MS Office. So if you already have MS Office then you’re good to go.

Secondly, get acquainted with the program. Learn what constitutes a “cell” as well as how to format the cell. You will have to decide whether the data entered into the cell should be considered as text, a number, or percentage, and whether you would like the number to include a dollar or percentage sign, commas inserted for every 100, and how far right of the decimal point you want to carry your numbers. You also need to consider such things as background colors, borders, font-size style, and cell size.

None of this is trivial and will be extremely useful once you start creating the reports you want to include as presentation material for your real estate analysis.

Thirdly, learn VBA (or visual basics for applications). This is the computer language for Excel that creates macros (procedures) that do something. For example, in my real estate investment software I rely on macros to create the toolbar and then to do something when some particular portion of the toolbar is clicked (e.g. the picture command enables users to select a picture from their computer and then automatically posts it into one or more reports). Macros can also be called from whatever form you’re using by including them in Excel’s built-in functions such as Worksheet_Change ().

You probably can get by without using VBA to write your own macros, but it will automate a number of features for your cash flow analysis if you take the time to learn it.

Fourth, learn how to use Excel’s formulas. One of the great advantages of using MS Excel is that it includes a wide-range of built-in functions that automatically compute such things as PMT (a mortgage payment), IRR (an internal rate of return), and NPV (a net present value) all based upon certain criteria. The problem here (at least as I discovered when developing my real estate investment software) is that the formulas don’t always produce the result expected. Some times, for instance, a number has to become a negative for the formula to compute correctly (though this is not made clear by MS). So it’s trial and error.

Fifth, you will have to learn how to compute the essential cash flows, rates of return, and profitability numbers that are essential to a real estate analysis. This has nothing to do with MS excel. You simply need to be able to compute the key real estate investing formulas to create a sound cash flow analysis. For example, cash flow before tax (CFBT) and cash flow after tax (CFAT), cap rate, gross rent multiplier, cash-on-cash, break-even ratio and so forth, as well as all the elements of tax shelter.

This is imperative. If you choose to create your own real estate analysis without the benefit of real estate investment software you must understand all the cash flow, rate of return and tax formulations otherwise you are sunk even before you set sail.

Finally, you will need to know how to create the essential real estate investing reports used for cash flow analysis. My own real estate investment software creates a wide-range of reports (and charts) but at the very least you will want to create an APOD and Proforma Income Statement. Feel free to see sample screenshots of all my reports on my website. Here’s to your success; may your real estate analysis spreadsheet serve you well.