How to Analyze an Investment Property Part 1

In Real Estate Investing there is always question as to whether or not a particular property is a good long term investment. This question is difficult for most people to answer because they do not know what other questions to ask. They may know to ask the simple things, such as how much it costs, how much can I rent it for, how much will it be worth in ten years, and the like, but these questions are not enough, although they are necessary. There are two basic parts to analyzing the whether or not to purchase a particular investment property: the quantitative and the qualitative.

In this post, I will address the quantitative, and I will address the qualitative issues at a later date. There are four basic legs, if you will, to every real estate investment: 1) Income, 2) Depreciation, 3) Principal Reduction, & 4) Appreciation. All four of these items must be considered, if one is going to have a complete view of the investment.

We are going to answer these questions with the use of an Excel spreadsheet, as I cannot post an excel spreadsheet I have created a .pdf file showing the relevant information; you will need to make the calculations manually, however. But if you e-mail me, I will send you the Excel spreadsheet. You can view the .pdf file here. This spreadsheet was primarily taken from a class I took from Tom Lundstedt. Tom is a fantastic teacher with a lot of great material. You can view his website at www.tomlundstedt.com.

Income is the first question if everyone’s mind. How much can I make? The questions seem easy to answer at first, but you need some key numbers to correctly answer this question. Let’s begin with a sample investment property; below is the relevant information:

Purchase Price: $125,000
Market Rent per month: $1,500
Annual Taxes: $700
Annual Insurance: $500

Begin by inserting the purchase price into the appropriate field on the spreadsheet, as well as the amount of cash you have on hand to invest. Let’s say that you have a 10 percent down payment. The spreadsheet will automatically enter the amount of financing you will need, but you will need to enter an appropriate interest rate. In the example, we are using 7.5 percent. You will see two financing columns: the one on the left shows the payment on a 15 year loan, and the one on the right shows a payment on a 20 year loan. The one of the left is used for the automatic calculations throughout the remainder of the spreadsheet. The one on the right is there for a quick comparison.

As you can see in our example, the payment on a fifteen year note is $1043 per month, which already makes this property start to look pretty good since the market rent is $1,500 per month, but let’s move forward, as there is much more to consider.

The second section is depreciation. Depreciation is a funny thing, as it can sometimes seem contradictory in Real Estate. For instance, if you were to buy an average car for $10,000, and then you were to try to sell it in two years, you might be able to get $6,000 out of it. We call that reduction in value depreciation. The car has depreciated due to normal wear and tear. The useful life of the car is most likely less now than it was two years ago when you purchased it. There may be exceptions to this, but it is most likely the case.

The reason that this seems contradictory in Real Estate is that traditionally Real Property has increased in value. This isn’t always the case, and it is definitely not the case in some markets currently, but historically speaking Real Estate has increased in value. But the IRS lets you treat the property like it is losing value each year, which is helpful to you because it reduces the amount of taxes that you will owe on the profit that you make on your rental property.

The IRS lets you depreciate different parts of your rental property at different rates. Below is an example of some rates:
• Personal Property—Refrigerators, ranges, dishwashers, carpeting, furniture – 5 years
• Land improvements (sidewalks, fences, landscaping shrubbery, septic systems, water pipes) – 15 years
• Residential rental property building – 27.5 years
You need to verify the depreciation rates with your own accountant.

Since the rates are in, you need to separate the value of the different parts of this investment property to determine how much will be depreciated at the different rates. I have determined the following values for this home: 1) Land–$18,000; 2) Personal Property–$6,000; 3) Building–$97,000; 4) Land Improvement–$5,000. The big question is how you prove your estimates are accurate. Well, your estimates must be reasonable, which is the first test, but the best way to make sure you don’t get in trouble with the IRS is to write these values into the purchase contract. If you and owner agree on these values and they are reasonable, then you should be fine, but you may want to still run it by your accountant. The spreadsheet is now telling us that we will have $4,826 in depreciation in the first year. This calculation would have to be updated for future years.

The next section is Gross Operating Income, the exciting part. The first number to enter is the annual rent, which in our case is $18,000 ($1,500×12). The second number is the estimated vacancy factor, which is the amount of time you would expect the property to not be rented during the year. In many markets 10 percent is a good estimate. The Vacancy Factor is deducted from the Annual Rent, which yields a Gross Operating Income of $16,200.

The next section is the Annual Operating Expenses, where we try to account for all cash expenses associated with the property. This is a pretty newly remodeled home, so we don’t expect many repairs, so we have left those at an estimated $500 per year; taxes at $700 per year; insurance at $500 per year; advertising at $50 per year for a few signs and line ads in the newspaper, which gives us a total operating cost of $1,750. Now that we have collected most of the data associated with this property, it is time to see what all these numbers mean.

Thanks to the Excel spreadsheet, all our entries will automatically calculate the following: Cash Flow Before Taxes (how much cash you actually put into the bank before you pay your taxes); Tax Estimate (how much taxes you can expect to pay on the income you earn); Principal Reduction (how much equity you will have built throughout the year on your mortgage); Appreciation (how much your property has increased in value).

Those values are as follows:

Cash Flow before Taxes: $1,935
Tax Estimate: $237 to the IRS, based on a 20 percent tax bracket
Principal Reduction: $4,077
Appreciation: 2% or $2,500

Those numbers are very important because the show actual dollar amounts, but they can be very difficult to compare when looking at another investment, which is why the Excel spreadsheet also calculates some ratios for us so that we can compare this investment with other investments to see which one gives the best return. Those ratios are:

Return on Investment (ROI): I calculate this with and without appreciation because you cannot always count on appreciation, and you need to be profitable without appreciation.

Capitalization Rate: The Cap Rate is an industry standard ratio that investors use to determine what type of return they will get. It is simply the Net Operating Income divided by the purchase price. A 12 percent return is pretty good.

Cash on Cash: This is my favorite ration because it shows how much return you are getting on the cash you have actually invested out of pocket into this investment property. You invested $12,500 cash into this property, and it put $1,935 back into your pocket this year, which is a pretty good return on investment.

All in all, it seems that this is a pretty good investment property from the financial side. But you would obviously need to compare it with other opportunities in the market to make sure that it actually is, but all things being equal, the numbers look pretty good.

Obviously, you will need to consider more than only the financial aspects of the investment, which I will deal with in a future post. Please let me know if you have any questions or corrections. If you provide me with your e-mail, I will be happy to send you the Excel spreadsheet with the formulas ready for simulating investments.

Joseph Griffin