How to analyze a real estate investment

If you're interested in getting into real estate investing... congratulations. But before you jump right in, make sure you understand the basics... what factors will contribute to your profit, and how you can screen properties for profitability before you buy.

There are 2 profit drivers in a real estate investment:

1) Appreciation of the property's value. This results in the whopping big gains you often hear about. The important thing to keep in mind about appreciation is that a) you can't actually get your hands on the profit until you sell the property (assuming you don't start playing financing games which are beyond the scope of this article), and b) a whole lot of factors can influence whether your property gains or loses value. Some of these factors would include the economy, the neighborhood, tax laws, interest rates, whether you under- or overpaid when buying the property, and your efforts to improve the property.

2) Operational profit, ie. rental income which exceeds your operating expenses. This is profit which you can get your hands on as it comes in, typically on a monthly basis -- you don't have to sell to get at it. With good planning, you can find a property where the operational profit will be enough to cover your mortgage and/or financing expenses, meaning that the building pays for itself and still leaves you with some extra pocket money. That's the ultimate situation.

So how do you analyze a prospective property investment?

First, you have to make a whole bunch of assumptions-- how long will you own the building for? What will be the rate of appreciation? What is your purchase price, your interest rate and your deposit? How about monthly expenses and capital investments (such as a new roof)?

You then use all of these assumptions to create a set of pro forma (ie. estimated) financial statements, with the main emphasis on determining the property's cash flow. Once you have estimated cash flow, you can use time value of money calculations to answer this basic question:

What is the value today of all future cash flows from this property?

This is a 'time value of money' calculation, which deals with the fact that, due to opportunity cost, a dollar you get tomorrow is worth less than a dollar you get today. The difference between those 2 dollars is opportunity cost.

This is a basic concept of all investing. It requires you to establish an interest rate which is called your 'cost of capital'. Another way of looking at it is-- what is the % of return you could get on your money by investing elsewhere (OR if you're borrowing the money to invest, you also need to take into account the interest rate you borrow at).

Once you have your cost of capital, and you know your expected future cash stream from the property, you can plug that data into a present value equation. This will give you the value TODAY of all of those future cash flows. Then you compare that value with the amount of cash you plan to invest in the property upfront. If there is money left over, it looks like a good investment. If the result is negative, it may not be. The amount left over is a financial metric known as Net Present Value (the present value NET of any cash you've put into the investment).

Is this complicated? Sure. Time-consuming? Yes. Necessary? Absolutely-- you're about to spend an awful lot of money, so you should feel confident that it's going to be profitable for you. 

The good news is that you can save an awful lot of time and number-crunching energy buy using real estate investment software. This is a tool which lets you plug in the numbers, and then spits out projected results.

To learn more, and to try out an easy-to-use web-based calculator, visit Real Estate Genius-- the original real estate investment analysis tool.