10 Minute Real Estate Lesson 3-Analyze This
Updated: Apr 14, 2020
There is arguably nothing more important in pursuing a real estate deal than doing a proper and thorough analysis to determine if the investment meets your goals. This analysis ranges from extremely basic and simple-determining whether or not the property is even worth pursuing further-to extremely detailed.
I will cover three different types of analysis that must be performed when pursuing a deal:
1. Hasty analysis
2. Pre-offer analysis
3. Post-offer analysis
Before we get started, it's important to highlight that this analysis should be done with your particular goals in mind. What you look for in your analysis will vary based on the strategy (buy-and-hold vs. flip), your desired source of income (cash flow vs. appreciation), and more. To be clear, my strategy is to buy-and-hold for cash flow, seeking a return of 12% on my cash.
This analysis works best if you have estimates for a few factors that you'll plug in throughout the steps. You should have a reasonable starting point for each of these numbers-interest rate based on pre-approval, insurance estimates based on quotes, property management rate based on actual cost, etc. I'm using the following:
Mortgage: 5% interest rate, 25% down on multifamily
Insurance: $75/mo (usually about $20-30 less, but a good conservative estimate)
Property management: 13% of rent (8% monthly + 50% first month’s rent annualized = 12.67%)
Reserves: 20% of rent (10% CapEx, 5% Vacancy, 5% Repairs)
Target return: 12% COCROI (Cash on Cash ROI = annual cash flow / total cash spent)
Finally, if you aren't already, you're going to want to be familiar with these two equations:
This is a very hasty analysis that should be complete no more than 2 minutes after getting the first view of the property. It could be from the MLS, from a Facebook ad, or really anywhere. The purpose of this immediate analysis is simple-does this property warrant a second look and more of my time?
In many cases, you are doing this analysis without realizing it. When you filter on multifamily properties under $350,000, you've moved 25 properties to the next stage and said no to everything else; when you look at one of those 25 properties and immediately close it because it's ripped down to the studs and you're not interested, you've completed a hasty analysis on that property.
Immediate analysis should consist of two steps:
Step 1. Does this property look like one I could pursue (using pictures and descriptions)?
Step 2. Does this property have the possibility to generate cash flow?
Step 1 is simple and includes what was just mentioned. Is the condition way too poor for you? Is it way too nice compared to what you look for? Does the description mention something like a foundation or termite problem that you want to shy away from? Most properties will be filtered out this way. If after the initial glance it looks like a possibility, move on to the next.
Step 2 is a back of the envelope calculation to get a ballpark estimate of whether or not the property could cash flow. I do this by using very rough but conservative estimates for rent (pulled from the lower range of rent values on Rentometer), the expense estimates cited in the introduction, and run the numbers assuming full list price.
This provides me with a very rough and quick COCROI to evaluate the deal based off of. Since my target is 12%, I'll typically continue digging deeper to conduct further analysis if my rough COCROI is greater than 8%. In most cases, I know that I can at least negotiate down from the list price, make improvements to increase value, and increase rent in an attempt to get to 12%.
If you've completed both steps and the property doesn't meet your initial criteria, congratulations! You've narrowed the field and don't need to waste any more time. If it does meet your criteria, kick it in gear and start the pre-offer analysis!
Here's where you dig in to confirm that the deal works for you and to figure out your limits on a potential offer. Ideally, you've built a network and have some of the resources in place to help you conduct further due diligence. If not, you can do it yourself through a little research. Over time, this should become easy.
There are 2 general rules of thumb to live by throughout this phase:
1. It's always better to err on the side of caution and be conservative in your estimates; better to have the unit rent for $100 more than you planned for than less.
2. Don't hesitate to walk away if it doesn't work.
You'll want to confirm a few things as a part of your pre-offer analysis, including your repair costs, monthly expenses, and rent. Let's take a look at how you can do each.
Repair costs. This doesn't need to be terribly complicated; your estimates should just be in the same ballpark. Start with the easy stuff first! If there are pictures, try to tell what improvements you'd make and roughly price them out. If applicable, check out the agent remarks and any attachments on the MLS (your agent can help you) to see if they’ve provided the status of any of the major capital equipment in the property.
You can also go see the property in person, although it's certainly not required and maybe not necessarily recommended if it puts you in jeopardy of losing a deal in a hot market. If it suits you though, go check it out! This could be as simple as driving by the house to get a feel for the exterior, or setting up a showing with your realtor.
**Quick note-be respectful of your realtor's time!!! If you're taking hours of his/her time driving to a dozen $60k houses all over the place that he/she is only standing to earn a meager 2% commission on, that's probably not a great use of their time. Respect their time and you will develop an invaluable relationship with them**
The final thing you can do is quite simple-ask! Have your realtor reach out to the listing agent to ask about deferred maintenance, capital equipment updates in recent years, or any other insight they can provide. They may not provide much, but you'll never know unless you ask!
Once you have these numbers, you should have a rough estimate of your repair costs. Don't forget to be conservative!
Your monthly expenses shouldn't be difficult to calculate. They consist of your mortgage payment, escrow (property tax and insurance), property management fees, reserves, and anything else such as utilities.
The mortgage payment is very straightforward to calculate based on your planned interest rate, particularly if you've been pre-approved prior. Add your escrow payments to this by confirming the annual property tax (bill is typically available on the county website) and getting a quote from your insurance agent. Be sure to shop your insurance options, but over time you'll likely get a feel for the price range to expect from an insurance company.
Property management is something you ideally have in your toolbelt already, but if not start networking to find a good one. Most charge 8-10% monthly, plus a tenant placement fee of 50-100% of first month’s rent. I like to assume annual turnover and calculate accordingly, meaning that 8% monthly with a 50% placement fee comes out to an annualized 12.167%.
Reserves are CRITICAL and often overlooked by new investors. Unexpected issues will pop up! Units will go vacant! You need a reserve fund to handle it. The amounts for repair and capital expenditures (Capex) can vary, but I like to typically account for at least 15% between the two. Just remember-a roof on a $100k house is not 3x cheaper than on a $300k house. So be sure to err on the side of caution with Capex.
\Finally, take other little expenses into account. Does the owner pay utilities? Are there lawn services that tenants don't take care of? Is cable or internet provided? All of these expenses should be accounted for.
Bring them all together and this should account for your monthly expenses, giving you a base for calculating your cash flow!
Finally, it’s time to zero in on the revenue you expect to generate. Rentometer is fantastic and I use it constantly, however it’s just a starting point and shouldn’t be taken as gospel…that’s why I start with the low estimate and work my way back up from there. You can ultimately review and confirm rent value a few different ways, but make sure you check multiple sources and never take a single recommendation as fact.
First and foremost, this is where a good property manager is like gold! If you have someone who is familiar with the area you’re looking at they can likely provide you with a good rental comp. If not, don’t worry! You have other options.
Websites and apps like Zillow and Trulia provide a great resource for finding rent values. Filter on units that are similar in size and number of beds/baths, and then look at the condition compared to what you’re looking to purchase. Additionally, you can check private listings on marketplaces like Facebook and Craigslist. I’ve found that these can often be cheaper and will help to even out your search. Be sure to check for similar units, both in size and condition, and use them to hone in on the true value. All of these sources combined should give you a pretty good indicator, but don’t forget to be conservative in your estimate!!!!
Determine the value.
The final step is to determine the value of your prospective property. This could warrant an entire post if its own, but for now I’ll try to hit the high points. In valuing your property it’s important to understand how an appraiser will value it so you know what to look for.
Appraisers use a combination of 3 different approaches:
Sales comparison approach - this may come as a surprise to hear that this approach…wait for it…compares recent sales. This is the most common method relied upon for single family homes, and is a huge factor in small multifamily properties (2-4 units) as well. In the sales comparison approach the appraiser looks at nearby (sold) properties of similar size with a similar number of bedrooms and bathrooms. In most cases, the location is the most important starting factor and rightfully so-most of us can think of an example where one or two blocks in another direction means a completely different neighborhood that you may want to stay away from. This drives value, so many appraisers will start there and adjust the value based on size/beds/baths and condition.
If you are analyzing a small multifamily property, it’s possible that comps in the immediate vicinity are unavailable. In the houses I’ve analyzed, where I may find 8-10 comps within 3 blocks for a single family home, I’ve only found 8-10 multifamily comps in the entire town. In this case the analysis becomes a little more complicated, and they may use a variety of metrics to come to a value including $/unit, $/bedroom, and $/sqft. Further adjustments can then be made based on condition and on location.
Replacement cost approach - I’m not going to insult your intelligence by telling you that the replacement cost approach uses an estimated replacement cost…ok maybe. Either way, this approach is another factor to look at along with the sales comparison approach. This is typically not weighted as heavily unless you’re looking at a new construction or something that there are no comparables for.
Income approach - while the sales comparison approach is the most prevalent, if the property is being used as a rental with strong income the appraiser can take the income into account. This is found by multiplying the monthly rent by the gross rent multiplier for your area. If you have a property with questionable comps and potentially lower value but it’s a cash cow, the income approach may bring the value up on it. For example, the after repair value (ARV) for my duplexes is around $190-200k with the sales comparison and replacement cost approach, and around $275k with the income approach. Taking all approaches together, the ARV is around $220k. As you can see, the income approach influenced the value but not as much as the other approaches.
My good friend Jake is an appraiser, and he likes to say that if you ask 3 different appraisers to tell you the value you’ll get 3 different answers. There is certainly a method to the madness, however as you can see there are also a number of variables that can make it difficult. That’s why appraisers exist. But if you can understand what they look for, you can have a better idea of how to analyze the ARV of a property!
How much should you offer??
Now as I said before, my niche is in buy-and-hold rentals and I invest for cash flow. In most cases the price is only important to me insofar as a) the house appraises, and b) it provides adequate cash flow. This means that frankly I don't care if I buy the house for full price as long as it provides the cash flow I'm looking for. I also understand this may not be your approach, so be sure to adjust your analysis accordingly!
That said, I will often use my estimates along with my target ROI to determine the highest price that I’d be willing to pay for a property. You can find this by finding the maximum cash you can spend to identify your max down payment and ultimately the max purchase price. One word of warning though is that if you do this in a silo without understanding the approximate value of the property itself, you may run into an issue with the appraisal or leave a significant amount of money on the table. That’s why I use this method as my driving factor, but evaluate the final number based on the estimated value of the property.
In the following example I’m looking at a property that requires $10,000 in repairs and cash flows at $576/mo. My closing costs typically sit around $6,500. Using those numbers, I can find my max purchase price:
As a result, I know that the most I can pay for this property is $164,400! I can put in an offer and be confident when I go into negotiations with the seller, knowing that if they refuse to sell it for $164,400 or less, I’ll say no. This takes the emotion out of the offer and negotiation and makes the whole process much simpler!
Congratulations! Your offer was accepted and you’re under contract! There is a lot that takes place from this point on, much of which is covered in my post on closing a deal. However for the purposes of completing your analysis, it’s important to take advantage of your due diligence period.
This is where you lock down your estimates. What does the inspector say? If you have contractors come out, what do they say is required and what’s the estimate? When you walk the property, did you identify other issues that would need to be resolved or amenities that would need to be provided in order to yield the rent you estimated?
Once you have all of these quotes and more concrete numbers, go back to your pre-offer analysis to plug them in! If you have repairs to make, does your cash flow still produce enough of a return with the added up front expenditures? If you can avoid making the repairs but see decreased rent instead, does the change in cash flow still meet your target return?
This is where you have to be prepared to walk away. If you’re familiar with “sunk costs”, this is where that comes into play for you…don’t chase a bad deal because you don’t want to “lose” the money you spent on the deposit, inspection, and/or appraisal. Renegotiate if you need to, or walk away if it doesn't work.
I had this exact situation happen to me last week – a property I had under contract ended up needing capital equipment replaced that was at least $10k more than I had planned for. As a result, my ROI was going to plummet. Unfortunately, backing out of the deal meant losing money…I would forfeit my $500 due diligence deposit, I had already paid for the $500 appraisal, and I had paid for the $550 inspection. But those expenses had already been paid and I wasn’t going to get them back. That was out of my control. What was in my control was refusing to pursue a deal that would have turned out poorly, so I backed out and I’m happy I did.
WRAPPING IT UP
The key to pursuing a good deal is conducting the analysis to understand that it is in fact a good deal, and that can be done in three stages:
1. Hasty analysis - quick 5 minute evaluation. Is this deal worth spending any of your time on?
2. Pre-offer analysis - thorough deal analysis. How good is this deal, is it worth pursuing, and how much should you offer?
3. Post-offer analysis - final confirmation of the numbers. Is your deal as good as you thought? Are you going to close?
Understanding these steps and the tools within each one can be extremely helpful to you in determining whether or not to pursue a deal, and in determining how much to pay. Master these steps and you can make sure that you only close on properties that are going to be profitable and in line with your goals!
Do you have tips and tricks that you've found successful when analyzing deals? Have you applied these principles with a result, either good or bad?? If so, please reach out to me or comment! And if you found this helpful, or think it may help someone you know, please share! I want to help as many people as possible apply the lessons I've learned.
If you have any comments or questions, or there's any way I can help you, please don't hesitate to reach out to me at email@example.com and follow me on Instagram at @investdgp!