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.