3 Rookie Real Estate Analysis Mistakes to Avoid

A real estate analysis is routine for investors and analysts trying to determine the cash flows, rates of return and profitability performance of any potential real estate investment opportunity.

The process is straightforward.

The financial data of the rental property is collected (i.e., rental income, operating expenses and mortgages) then the numbers are mathematically “crunched” in order to establish the bottom line cash flow, rates of return, and profitability the investor might hope to achieve by owning the property.

As a result, the need to create a sound real estate analysis with realistic numbers is a must for the evaluation and subsequent real estate investing decision that will be made by the investor.

Nonetheless, it’s also not uncommon for less experienced agents and novice investors to inadvertently skew the bottom line with data that is faulty due to their lack of experience to correctly interpret the data.

In this article, I want to share with you three places where novices commonly make a mistake about a rental property’s financial performance. Hopefully it will help those of you new to real estate investing to avoid the same.

1. Vacancy Rate Factor

The income stream an investment property produces is paramount to an investor because it’s what will determine the bottom line. But rental income must always be tempered by the amount of vacant units the property possesses.

An apartment building with ten units, for example, might produce a monthly income of $10,000 if all ten units are rented for $1,000 per month. On the other hand, if two of those units are unoccupied, the actual monthly income would only be $8,000.

Okay, so here’s where novices tend to make a mistake. They routinely show the vacancy rate factor currently experienced by the property — sometimes even when its at zero percent. But this might not be the reality for a new owner.

Bear in mind that market conditions, property wear and tear, rent increases, and even a change of ownership can (and often do) cause vacancies.

So look beyond a property’s past and present financial performance when you create your real estate analysis, and always include an allowance for vacancies characteristic to your local market.

Unless there’s a cause to think otherwise, a factor of 5% is typically safe for vacancies and often used by bank appraisers.

2. Maintenance and Repairs

The cost to maintain and repair an income property is an operating expense that every owner will endure because appliance parts break and screens tear.

It is a mistake, however, to create your analysis based upon the actual amount the current owner has spent for maintenance repairs during his or her ownership because it might not be relevant to what a new owner might spend in the future.

The existing owner, for instance, might have benefited from lower costs because he or she did their own repairs, or perhaps had a close relative who did. The new owner, on the other hand, might be required to contract all the repairs and maintenance out at top dollar.

It’s important not to ignore what the owner has done to upkeep the rental property, but just be sure to always include some percentage of the gross operating income that better reflects what a new owner may have to pay.

I always felt comfortable using 4-5% for newer property and 6-8% for older property. But this is completely arbitrary, so do a little research to see what percentages might best apply to your market area.

3. Replacement Reserves Omission

Replacement reserves is money a real estate investor sets aside to cover any future replacements for worn out items he or she may incur after the property is purchased.

It’s not an operating expense that the investor must cover on a regular basis to keep the property in service like property taxes, utilities or trash. But it is smart to consider some allowance for replacement reserves up front so the investor can get a truer look at the property’s projected cash flows and rates of return.

Most analysts figure this on the basis of x-dollars per unit annually. If the property consists of twenty units, for instance, and the analyst chooses to use an amount of $300 per unit, then the real estate analysis would reflect the amount of $6,000 annually.

So You Know

All ProAPOD real estate investing software solutions provide user-friendly forms that make it easy to enter vacancy rate, repairs and maintenance, and replacement reserves.

 

Want a Quick Way to Caclulate Mortgages, Cap Rates, Tax Shelter?

tax shelter calcsUsing a hand-held calculator to make calculations for mortgages, real estate investment investment returns like cap rate and cash-on-cash as well as the tax shelter computations for such things as sales proceeds after tax requires maximum effort.

I know.

As a real estate professional with over thirty years experience selling investment real estate with Coldwell Banker and Prudential I always had to rely upon a hand-held calculator to do my simple and complex calculations. It was reliable, of course, but for many of the computations it was also very tedious.

So I decided to develop a calculator to that would make it easier; a calculator I can access online with my computer or iPad that would cut the effort and time a hand-held requires to practically nothing. So I developed iCalculator.

iCalculator is a 100% web-based HTML solution that can be accessed 24/7 from any device that connects to the web and requires nothing more than a few form entries and the click of a button to compute a host of mortgage, time value, investment and tax shelter calculations.

depreciation-allowance

click to enlarge

As an added benefit iCalculator also includes a full mortgage amortization table and the formulas to many of the most popular real estate returns so you get complete function plus a learning tool.

iCalculator includes free updates and comes with a 5-day 100% money-back guarantee.

So you can try it totally risk-free. If you decide not to keep it you get your money back – no questions asked. If you decide to keep it, then count on never getting all future updates absolutely free.

Plus, you can save over 64% off the retail price. Educators, students, and all real estate professionals pay just $24.95.

You can learn more about iCalculator, including the calculations and functions, along with additional screenshots at iCalculator education and real estate community page.

 

Inflation Rate Calculator, Update 10-5-13

iCalculator iCalculator, the innovative online real estate calculator provided by ProAPOD, has updated its inflation rate calculator to adjust to the latest US government CPI data released September 15, 2013.

As a result, you can now use the inflation rate calculator in iCalculator to compute annual inflation rates starting as far back as the year 1913 through August, 2013.

Current users of iCalculator do not have to pay for this inflation rate calculator update. Updates made to this online real estate calculator are always free following your purchase. So the next time you login and start calculating, the current inflation rates, along with any other updates we may have made, will be computed automatically.

Real Estate Capitalization Rates

cap-rate

cap-rateCapitalization rates (or cap rates, as they are more commonly called) are one of the most popular returns associated with real estate investing.

As such, it’s not uncommon for a cap rate to appear in a real estate analysis inside reports like an APOD or proforma income statement.

Those of you who have been engaged with rental income property for any amount of time are certainly already aware of this. So to you, capitalization rates aren’t a mystery.

On the other hand, beginner real estate agents and investors with less rental income property experience would naturally have questions and want to know more in order to make proper use of this popular return.

So it seemed needful for me to present an overview.

Meaning

Capitalization rate is the rate at which you discount future income to determine its present value.

But this is the technical definition and really will mean little to you in the real world, so allow me to generalize what it means in practice: A cap rate expresses the relationship between a property’s value and it’s net operating income.

Net Operating Income / Property Value = Cap Rate

In other words, it shows what percentage of a property’s value (or sale price) is attributable to its income stream.

This is significant to real estate investors because net operating income is the amount of cash flow available to make the mortgage payments. And in cases where the investor is making an all-cash purchase without a mortgage payment, the cap rate is virtually the investor’s rate of return on that income stream.

It stands to reason, therefore, that real estate investors would want to base their investment decision on the highest capitalization rate possible.

Remember, higher capitalization rates mean more net operating income related to price and therefore imply a higher rate of return produced for the investor by the investment, and vice versa.

Application

Cap rates are routinely used by real estate investors, agents and analysts for several informative reasons.

  1. To gauge and compare the financial performance of various real estate investment properties. This is helpful when multiple rental property’s are being considered.
  2. To determine whether the asking price of an income property is in line with the price comparable income properties recently sold. This helps to prevent paying more than market value.
  3. To establish an asking price for an investment property about to be listed for sale based upon local market values.

Nuances

There is no such thing as an “ideal” or “standard” cap rate. Capitalization rates for real estate are market driven.

  1. Foremost, they are based upon the real estate investor’s personal investment objective, which, of course, is highly arbitrary and does vary from buyer to buyer.
  2. Secondly, they are based upon the property’s location, rent stability, condition, neighborhood risk and appreciation potential. You would not expect a relatively new property located in a well-kept neighborhood near a city’s growth corridor to have the same value to a buyer, for instance, as an older property in need of repair located in a deteriorating part of town.
  3. Thirdly, they are based upon the geographic market location of the real estate. An apartment complex located in Orange County, California, for example, would likely support higher values marked by lower capitalization rates than a complex located in Detroit, Michigan.

So You Know

All ProAPOD real estate investing software solutions automatically compute cap rates and include them in the appropriate real estate analysis reports.