How to Analyze a Real Estate Deal – Will It Cashflow?by
We’ve been to some real estate programs where they promise you can do deals from the comfort of your own home. “All you need is a computer, internet access and a telephone and you’re in business,” they suggest. No matter how great technology gets there is nothing that replaces actually being there, smelling the house, and seeing the area first hand. There is a lot more to analyzing a property than just running numbers – no matter what your exit plan is.
I walk into a property and can figure out whether we should buy it in about sixty seconds. I can quickly guesstimate what the rent we can get is (we’re sub-market area experts, so I know what rents for what price in this area off the top of my head); and I know the price range within which I can buy this place and make it work because we’ve done so many deals.
I also get a feeling from a property. You probably do too – even if you don’t pay attention to it yet!
Feelings, of course, aren’t enough to buy a property on though. You are looking for the real estate deal that is going to meet your goals. To achieve that, you’ll need to be able to analyze and value the property and figure out if it’s going to make you money.
Your job as you evaluate specific properties is to disregard the list price or what the sellers may want for it and focus solely on what it’s worth to you!
Don’t worry about the city’s property assessment or about what the sellers paid for it. Those numbers are mostly irrelevant. You may be able to use them in your negotiation if it comes to that, but for the purposes of evaluating the property they’re not important.
As you look at the property, consider the following:
- What is the area zoned for? (What else can you do with it? Can you add retail or office space or additional units?). What is its highest and best use?
- Are there any restrictions on the use of the property?
- What is the immediate area like? Are the other houses well maintained or not? Are there parks?
- What is in the area that is attractive for someone living there? Schools, shopping, medical services, police/fire and other services?
- What kind of transportation options are within a few blocks?
- What condition is the property in? Exterior and interior?
- What is your gut telling you when you see the property? How do you feel when you’re in the property?
- Are there easy things you can do to improve the appearance of the property?
- Are there any environmental risks to consider? Earthquakes, hurricanes, mold, termites, asbestos, bed bugs, etc.?
- Who lives there now? Tenants or the owners?
Some of these things you can assess using maps and information you can gather from the internet, but most of these questions require you to physically be there to properly answer them.
Then, to figure out values, you’ll need to do the same evaluation for other properties that are on the market, as well as those that have recently sold in the area. You’ll also have to spend some time figuring out what kind of rent rate you can get for the property.
If two properties are comparable in size and location, yet one property (on a dollar per sq. ft. basis) is much more expensive or much cheaper, it’s your job to figure out why. The cheaper property may be in a slightly worse location. Or it could be on a noisier street, or near a garbage dump, or in a position where it gets less sun, etc. These are some of the things you’ll need to determine to figure out value and possible rent rates.
What You Need to Analyze a Real Estate Deal & Calculate the Cashflow
You will need to gather most of the following information to calculate cash flow:
- Property taxes
- Heat/hydro (and who pays for it – the potential tenant or the owner?)
- Electricity (again, who pays for it?)
- Garbage/sewer/recycling fees
- Property insurance (you can speak with an Insurance Broker for an estimate)
- Property management (again, you will want to research this to get an estimate)
- Maintenance of the building/property.
Separate from the above, you will want to come up with a rough idea of how much you will have for a down payment – so you can estimate your financing costs – and also get an estimate of the current interest rates. (You can check this online or speak to your bank or a mortgage broker.)
Many of the items above can be estimated until you have an accepted offer on the property, at which point you’ll have easier access to the real numbers. However, the more actual numbers you can obtain from the seller (or seller’s agent) and from your various sources (banker, broker, insurance agent, etc.), the more accurate your cash flow prediction will be.
Whenever we begin analyzing a real estate deal, we always use the following rule:
Income/Financing Ratio: 65% of income should be the maximum financing (mortgage principal and interest ) cost.
E.g., if rent is $2,000/month, financing should not exceed $1,300/month (2,000 x .65 = $1,300).
Hopefully its obvious that you’re going to take the monthly rent (and any other income like monthly parking or laundry income) and subtract all the monthly costs. If an expense only comes in an annual amount (like insurance or property taxes, for example) simply divide by 12 months in order to get your monthly rate.
We look for deals that are going to cash flow at least $300-$400 each month. That gives us room to wiggle if rent rates drop or we have some other surprise.
A Few Words of Caution … Just Because Your Number is Positive Doesn’t Mean It’s a Good Deal:
Did you include an amount for property management (usually 10% of your monthly rent cost). Even if you are going to manage the property yourself, it’s always wise to have a buffer – in the event there comes a time where you can no longer manage the building yourself and need to hire a professional. Sometimes, when we’ve moved cities, changed to more demanding jobs, or just couldn’t handle the strain and stress of managing the properties, we’ve gone from self-managing to professional management!
What rent did you use? Is it likely? Knowing only the expenses won’t help you if you haven’t determined what rent you’ll be getting. It’s imperative that you obtain accurate rental information in your chosen area and for comparable properties. You need to be a shopper of comparable properties. If it’s 3 bedroom house with a 2 bedroom suite you need to look at all the local listings and see what is comparable and what they are asking. Ideally, call a property manager and ask them what it would rent for.
If your chosen property is already rented, then hopefully you were able to find out the current rent from the listing, the Listing Agent, or your Agent. Are the current tenants in a lease already, or is it just month to month? Asking the rent rate that the current tenants are paying is not enough research. It’s entirely possible they are paying way more or way less for some other reason (family, friends, etc.) but it’s still important to know what they are paying.
There’s a lot to cover when it comes to analyzing a deal and figuring out if it will cash flow. Hopefully this gets you started. One thing we haven’t addressed much at all is the risk. Here are some other articles you may like that will help you with analyzing your real estate deals:
Photo credit: Julie Broad (that is a picture of the house we just added a legal suite to)