How to Analyze a Real Estate Investment Property

Knowing how to analyze an investment property is the first step to making sound real estate investment decisions. We have put together an educational video so that you can learn how to analyze an apartment building.

At Sage Real Estate, your market leader in Long Beach fourplexes, we are dedicated to helping our clients buy and sell apartment buildings. We will be explaining how to analyze an investment property using our custom 5-2-1 Sage Formula.

Many investors we work with have the same questions:

• “How much should I offer for a property?”
• “Will I achieve a good rate of return on a property?”
• “If I buy a property will it give me money each month, or will I be losing money each month?”

There are two primary categories when considering purchasing an investment property:

1. Financial: What do the numbers look like? Will the property make me money?
2. Physical: What condition is the property in? Does it need work or is it move-in ready?

Both categories are equally important, but in order to property analyze an apartment building, we need to analyze the property’s financials.

To analyze and appraise an apartment building, we have developed a custom Sage Real Estate 5-2-1 Formula:

• 5 investment property calculations
• 2 investment strategies
• 1 exit plan

​5 Investment Property Calculations

1. Gross Rent Multipliers (GRM)
2. Capitalization Rate (Cap. Rate)
3. Price Comparison (Price per foot and Price per unit)
4. Cash-On-Cash Return (What return are you getting on your money?
5. Debt Service Coverage (Does the property pay for itself?)

Example Analyzing a Fourplex:

• Sold Price: $1,100,000
• Square Footage: 3,656 sq. ft.
• All 4 units are 2 bedroom, 1 bath
• Rents for each unit are $1,500 per month

1. Property Value with GRM
   • Step 1: Determine gross annual income.
     • $1,500 x 4 units = $6,000 gross monthly income.
       
       $6,000 per month x 12 months = $72,000 gross annual income
       
   • Step 2: Derive the gross rent multiplier for the area that the property is located in.
     • In most cases, you will need a local real estate expert for this step.
     • To determine this on your own, you will need a list of similar properties that have recently sold in the same area with their sales price and their gross annual rental income.
       
       Price / Gross Annual Income = GRM
       
   • Step 3: Multiply the gross annual income for the property you are considering by the GRM for the neighborhood.
     • Using the same example, let’s assume the GRM for the neighborhood ranges from 12 to 14.
       
       $72,000 x 12 = $864,000
       $72,000 x 13 = $936,000
       $72,000 x 14 = $1,008,000
       
       If you are able to purchase below the GRM for the neighborhood, you are likely getting a good deal on an apartment building. If you purchase above the GRM for the neighborhood, you may be paying too much for a property.
       
2. Property Value with Capitalization Rate:
   • Step 1: Subtract operating expenses from gross annual income
     • Operating expenses generally equal roughly 30-30% of gross rents and commonly include:  vacancy reserve, property taxes, insurance, utilities, and repairs
       
       Gross Annual Income – Operating Expenses = Net Operating Income (NOI)
       
       $72,000 – $21,000 = $54,000 NOI
       
   • Step 2: Divide NOI by property’s asking price or your desired Cap. Rate (also know as rate of return) (using the IRV formula as shown in the video)
     • Similar to GRM, the Cap. Rate must be derived and compared to similar properties in the same area
       
       NOI / Price = Rate of Return OR NOI / Rate of Return = Price
       
       $50,400 / 5% = $1,008,000
       $50,400 / $1,008,000 = 5%
       
3. Property Price Comparison: Price per foot and Price per unit
   • Step 1: Find the most similar properties near the property you are considering to purchase. (You may need a local real estate expert for this step).
     
   • Step 2: Divide the price of the property you are considering by the square footage and number of units.
     
     $1,100,000 / 4 units = $275,000 per unit$1,100,000 / 3,656 Square Feet = $300.88 per foot
     
   • Step 3: Compare this to the surrounding market. If you can purchase below the area’s price per foot or unit, this may be a good investment.
     
     These first three metrics are used for calculating property value. The next two cover rates of return and debt servicing.
     
4. Cash-On-Cash Return: The income that the money you put into the property is generating for you
   • Step 1: Add the annual mortgage payments to the operating expenses to get total expenses.
     
     Operating Expenses + Mortgage Payments = Total Annual Expenses
     
     $21,000 + $24,000 = $45,000 Total Annual Expense
     
   • Step 2: Subtract total expenses from Gross annual income.
     
     Annual Gross Income – Total Annual Expenses = Cash Flow (Pre-Tax)
     
     $72,000 – $45,000 = $27,000 Cash Flow before tax
     
   • Step 3: Divide the pre-tax cash flow by the total spent to purchase the property (in this example the down payment was 30%)
     
     Cash Flow / Down Payment = Cash-On-Cash Return
     Down Payment = $1,100,000 x 30% = $330,000 to purchase the property
     $27,000 / $330,000 = 8.18% Cash-On-Cash Return
     
     Cash-On-Cash and Rates of Return are different for each investor. You should explore alternative properties and investments to see which rate of return is best for you.
     
5. Debt Service Coverage: Does the property pay for itself?
   • Step 1: Use the pre-tax cash flow calculated in the Cash-on-Cash return portion.
   • Step 2: Determine if the cash flow is positive or negative
     
     If cash flow is negative, the property is not paying for itself and you will be paying out of pocket to make up the difference.

2 Investment Strategies

Typically you can only choose one, as investment properties rarely provide both:

1. Appreciation (also know as “equity growth”)
2. Cash Flow

Various investments in different areas will either produce cash flow, or increase in value over time. In Southern California, many investors buy properties for their consistent appreciation in value.

In other areas of California and other states where properties are cheaper, they are more likely to produce positive cash flow.

1 Exit Plan

Important questions to ask when developing the investment exit plan:

• How long are you going to own the property? 3 years? 5 years? 10 years? Forever?
• Am I buying a property to fund my retirement?
• Am I purchasing a property to create generational wealth (i.e. leave the property for your kids)

A clear exit plan reduces potential conflict amongst business partners, investment partners, or whoever you are purchasing the property with.

Knowing how long you want to own the property, and the goal of ownerships, plays a key role in knowing what to do when the real estate market fluctuates.