Introduction to Real Estate Investment Analysis

Ready. Set. Let’s analyze!

How long do you spend picking out clothes each morning? Probably longer than most investors spend doing the math for real estate investment analysis. People choose deals based on intuition, not analytics.

You want to know how to leverage your investment properties, but digging into deal analysis details might feel like a trip to jargon town. Cap rate? NOI? Cash-on-cash return? Total return?

Feel bewildered as you start investing? You’re not alone. We get a lot of posts on the BiggerPockets forums asking about real estate investing analysis. Here, we’ll dive into investment analysis, how to perform it, and how it can help you develop your real estate investment portfolio.

What Is an Investment Property Analysis?

An investment property analysis is a key element of any good investment strategy, whether you want to buy office buildings or residential properties as a way to invest in real estate and take advantage of potential investment property value gains. 

This process helps real estate investors determine their real estate investments’ current performance and identify areas for improvement. In its basic form, real estate investing analysis involves calculating investment returns.

Choosing an Investment Property Type

Before diving into real estate investing, make sure you understand how to compare markets and investment properties. Whether you’re trying to decide between investing in Boise or Sacramento or comparing two similar homes, read our beginner’s guide to market analysis. 

While you may have only worked with a real estate agent to find a primary residence to live in, you can also work with a real estate agent to help you find good investment properties that meet your needs (whether a residential property or a commercial property). You also have the option to look for a real estate investment property on your own by using online real estate platforms. 

The projections, or investment analyses, give detailed assessments of how future returns will be impacted by current costs and expenses, taxes, loan values/equity, and other factors that can impact your ROIs. Investment analysis is a better, more precise tool for an investor than simply calculating cash-on-cash return, for example, because it includes the many variables that impact real estate investment.

Single-family homes

When looking to find investment properties, you may want to consider single-family homes that can act as renters’ primary residences. Market comps determine the value of these homes, investment or not. 

These comps—or “comparables”—are nearby potential rental properties with similar characteristics. This type of investment property shares variables like the floor plan, number of bedrooms and bathrooms, garage size, and amenities. This type of investment property generally rises in value if a similar home also rises—and vice versa.

Multi-unit properties

Larger investment properties—with at least two units, and especially those with more than four—are priced and valued differently. The value equates directly to how much income or profit the investment property produces. An apartment building in a neighborhood where house prices are dropping could, in fact, increase in value.

You can’t just compare your apartment building to others down the street to see how much it’s worth. That’s why real estate investment analysis is so important.

There are several primary factors to consider, but cash flow and appreciation are the two most important variables. Cash flow is simply the money left after all the bills have been paid, and appreciation is the equity gained as the investment property value increases.

There are not many great ways to estimate future appreciation for commercial properties or residential properties without a crystal ball, so I generally focus on cash flow.

Vital Elements of a Real Estate Investment Analysis

So, now that you know what investment property type you’ll be analyzing, you can move on to the analysis. 

These are the main steps to evaluating a property’s investment potential. It combines several real estate evaluation methods to give the most accurate ROI prediction possible. Note the word ‘’prediction’’ here: It’ll never be 100% accurate. An analysis is just that: It gives you an estimate or a prognosis. It gives you potential return numbers, which are not guaranteed. 

Remember that investment property buying comes with risks, whether you own only one investment property or are one of the most successful real estate developers out there buying billion-dollar commercial properties.

Let’s take a sample investment property: 1950 Maybury Street. Here are the stats:

Good financial analysis involves inputting key information metrics into a financial model and using its calculations to determine whether the investment is good or bad—and right for you. You’ll need to know these variables for the most thorough financial analysis of residential rental property:

• Investment property details: Number of units, square footage, utility metering design, etc.
• Purchase information: Total purchase expenses—or purchase price plus rehab or improvement costs and closing costs
• Financing details: Mortgage or loan information, such as the total loan amount, down payment, mortgage interest rates, and closing costs
• Income: Monthly rent payments and any other income the investment property produces
• Expenses: Maintenance costs, including property taxes, insurance, and repair costs

Where to find data

• Property details should be available from the seller. Check with your local records office for more comprehensive, detailed information.
• Purchase information includes any up-front maintenance or improvements that must be completed before the property can meet its income potential. Have the property inspected to ensure there are no hidden issues or problems.
• Financing details can come from your lender or mortgage broker.
• Income details come directly from the seller—but don’t rely on pro forma data. You can also talk to the property management company currently handling the property, if one exists, for this information.
• Expenses should also come directly from the seller or property management company. A building inspector can warn you about any major upcoming repair costs, such as a new roof or HVAC system.

Pro forma vs. actual data

Getting good data from your model requires reliable, accurate information. Remember: It’s in the seller’s best interest to provide appealing—not accurate—numbers. For example, they may provide high rental property income estimates or neglect to mention certain maintenance expenses. Part of the investor’s job is to ensure you have the best available information.

“Pro forma”—or estimated—data from the seller merely kicks off the discussion. Before closing,  determine the actual numbers. Ask to see previous years’ tax returns, property tax bills, and maintenance records. Hopefully, the actual data is similar to the pro forma data—but it may be different.

Check for potential surprises, too. For example, when was the last time the property was assessed for taxes? If it was a while ago and values have increased significantly, it’s possible the property will soon be reassessed and taxes will increase. Even small changes to the income and expense numbers can mean big changes in your bottom line.

Comp analysis

Comp analysis is short for comparative market analysis. Quite simply, it’s a way to predict the value of a real estate asset by comparing it to the real estate values of similar assets recently sold. Real estate professionals use various metrics to perform a comp analysis: typically, the size, age, and location of a property, as these can be compared on a like-for-like basis.

Rental comps are calculated the same way sales comps are, but instead of determining the potential sales price of a home, you will determine how much rental property income it generates.  

Comp analysis can be performed for any building type, from a single-family home to a 100,000-square-foot office building. Plenty of digital tools and services can give you the right data, including sales history, to perform comps on commercial real estate.

Income analysis

Income analysis, or the income approach, is one of the most popular real estate valuation methods. It has a simple formula: net operating income divided by the capitalization rate (projected rate of return). We consider both elements of this equation in more detail below. 

First, let’s find out how to work out our net operating income on real estate. 

Assessing property income

Gross income is the total income generated from the property. When you collect monthly rents and other income from things like laundry facilities and parking fees, you generate income. For example, 1950 Maybury has eight units renting for between $525 and $650 per month, for a total of $4,500 per month. In addition, there’s $2,400 per year in additional laundry facility income. That means the total monthly income is $4,700, and the annual income is $54,000.

Most of a property’s income generally derives from monthly rent—making it extra important to account for unit vacancy. Most areas have an average vacancy rate, although your property’s specific vacancy rate may be higher or lower. If so, you’ll want to factor that into your analysis.

Here are questions to ask if the vacancy rate doesn’t correlate with the average local vacancy:

• Is the data pro forma or actual? If actual, what is the current management doing to keep the building filled?
• Is the rent lower than market rent?
• When do current leases expire?

You’ll need to determine what you think is a reasonable vacancy rate going forward—I recommend erring on the conservative side.

Before you start to generate rental income on real estate investments, get an idea of how much rental income you can expect to earn from your real estate investment. Start by subtracting the income that you likely won’t see due to vacancy. In our example property, only one out of eight units are vacant, equating to about 12% vacancy. We’ll use that number for our analysis. This means our total monthly income would be $4,160, with a total annual income of $49,920.

Calculating net operating income

A cornerstone metric of your financial analysis is net operating income (NOI). This determines the property’s total income after all expenses or your mortgage loan costs.

In mathematical terms, NOI equals the total income of the property minus the total expenses of the property:

NOI = Income – expenses

Typically, NOI is calculated monthly using income and expense data, which can be easily converted to annual data simply by multiplying by 12. 

Analyzing real estate expenses

Now let’s calculate the total expenses for this property. In general, expenses break down like so when you invest in real estate:

• Property taxes
• Insurance
• Maintenance: Estimated based on the age and condition of the property. Maintenance expenses will include repairs. When estimating potential repair costs to budget for, look at the property itself. Generally, you can assume between 5% to 15% of the rent, depending on the condition and age of the property. And remember, you may go six months without a single repair and then get hit with a $1,500 water leak. 
• Capital expenditures: Also known as CapEx, this means those expensive big-ticket items that need to be replaced every so often, such as roofs, appliances, and HVAC systems. For each major system, estimate the cost to repair, divided by the remaining life span, and set aside that amount every month.
• Management, if you employ a professional property manager. Property management companies typically charge a percentage of the rent and a fee to rent out a unit. These numbers can change based on your local area, but in my area, property managers charge 10% of the rent and 50% of the first month’s rent when a unit turns over.
• Advertising
• Landscaping, if you hire a professional landscaping company
• Utilities, assuming any portion of the utilities are paid by the owner

Convert any monthly expenses to their annual costs to find the property’s annual operating cost.

Now that we know our total annual income and expenses, we can calculate NOI:

$49,920 – $12,751 = $37,169 NOI per year

NOI doesn’t give you the whole picture or enough information to make any decisions, though. Instead, it is the basis for calculating most of the important metrics in our analysis.

Common Real Estate Performance Measurements in a Real Estate Investment Analysis

We’ve learned that NOI is the property’s total income. But you might wonder, “Why doesn’t NOI include the expensive cost of the loan, since that will ultimately affect your bottom line?”

Now it’s time to get serious about cash flow.

Cash flow

Cash flow is the money left over after all the bills have been paid. However, this simple definition gets many people in trouble. Technically, cash flow is:

Income – expenses = cash flow

But income may include more than just the rent, and expenses will include more than just the mortgage. Unlike NOI, cash flow also includes your interest expense under “expense.” 

The higher your loan payments, the smaller your cash flow. If you pay cash for a property, your cash flow is the NOI exactly because that’s the property’s maximum cash flow.

The monthly debt service on Maybury is $2,129, making the annual debt service $25,548. For this property, cash flow would be:

$37,169 – $25,548 = $11,621

BiggerPockets has a handful of investment calculators to help with these formulas.

Rate of return

Cash flow isn’t the only important factor. You must consider the rate of return—also known as return on investment, or ROI—too. ROI is your cash flow relative to the cost of your investment, or your “basis.”

Mathematically, that would be:

ROI = Cash flow/investment basis

What is a reasonable ROI? Let’s compare other investing vehicles:

• High-interest savings accounts often have an ROI, or interest rate, of between 2% and 5%.
• A certificate of deposit (CD) sports an ROI of about 5%.
• The stock market has an average ROI of about 8% and 10%.

So what’s our ROI on Maybury? You should consider a few numbers in your real estate investment analysis. Here’s more on calculating rate of return.

Capitalization rate (or cap rate)

Just like NOI is completely independent of financing costs, cap rate is a neutral figure independent of the buyer or their financing. It’s calculated as follows:

Cap rate = NOI / property price

Cap rate may be the single most important number in your real estate investment analysis. The cap rate, or capitalization rate, is independent of the buyer and financing, making this calculation the purest indicator of a property’s potential return.

Here is the cap rate for Maybury:

$37,169 / $418,000 = 8.89%

Here’s more on how to calculate cap rate.

Cash-on-cash return (COC)

Just like there are multiple income measures—NOI and cash flow—there are also multiple measures of return. The cap rate is the rate of return independent of financing, and the cash-on-cash (COC) return is dependent on financing. It’s directly related to the amount of cash you put down.

If you put $100 into a savings account, you might receive $4 per year, or 4% ROI. The COC measures your return if you put that $100 into the property instead. COC is calculated as follows:

COC = Cash flow/investment basis

For Maybury, the annual cash flow is $11,621. In total, the down payment, improvements, and closing costs equal $98,000, creating a COC of 11.86%.

Here is a more detailed look at how to calculate COC.

Total return on investment (ROI)

In addition to cash flow, there are several other key financial considerations in your real estate investment analysis:

• Tax consequences: You may gain or lose money to taxes.
• Property appreciation: The real estate market is volatile, so you may not be able to predict this.
• Equity accrued: This is the difference between the value of the investment and the amount remaining on the mortgage. Remember, your tenants’ rent covers the mortgage payments.

COC only considers cash flow’s financial impact; total ROI considers all the factors affecting your bottom line. It’s calculated as follows, where “total return” contains all the considerations above.

Total ROI = Total return/investment basis

Let’s assume we can expect a 2% yearly appreciation for Maybury—or $8,360. The equity accrued in the first year of the mortgage is $3,251. And for this example, no tax breaks are available—or taxes are due.

The total return for Maybury would be $23,232, making the total ROI 23.71%.

Here are some tips for how to calculate ROI on a rental property.

Analyzing Real Estate Investing Metrics—In Conclusion

Real estate investment analysis involves a series of number-crunching exercises that can help you predict your ROIs with a high degree of accuracy. Rather than relying on a single metric (e.g., cash flow or COCs), an investment analysis takes advantage of all metrics available to an investor to predict returns. 

As mentioned, no investment analysis can be 100% accurate. However, perseverance over time will pay off when you invest in real estate. 

No, you can’t predict the future—but you should extend your analysis out a couple of years using trends or demographic data indicating the direction of the market and inflation. The more data you collect consistently, the better your projections will be. The better analyses you are able to make, the better you will become at choosing investment properties that deliver returns worthy of your money and effort.