Thinking About Deal Analysis as a Beginner

So you have decided you want to purchase your first rental property. You've been saving for months, or even years, and you're excited to begin your journey and start earning some side hustle income. The problem in front of you: how do you determine if a property will make you money?

There are endless resources to teach you the concepts of financial modeling, but they can feel overwhelming and complex. There's an alarming number of new acronyms to learn, and Excel equations to become familiar with. If you're at the start of this learning journey, and have felt the feelings described above, allow me to offer a framework for thinking about the task at hand. I submit this as a method for easing the learning curve, and inspiring confidence earlier in the process.

You need a goal when doing analysis. Broadly speaking, your goal is to know if this deal is worth pursuing. Said differently, you need to reach an estimated return metric, and then decide if it's high enough/low enough to move forward. There are several return metrics, and every investor chooses a different one as the deciding factor in their decision making process. We have equity multiple (EMx), cash on cash return (CoCR), and internal rate of return (IRR), for example. Everything you learn in regards to deal analysis is toward the goal of reaching one or several of these metrics. 

There are two numbers you need to get to those metrics, net operating income (NOI) and free cash flow (FCF). These numbers are almost self-explanatory. NOI is the income from the property minus the operating expenses, and FCF is found when we take that NOI number and subtract the mortgage payment dollar amount for the same time period (commonly done on a yearly basis - in which case it's referred to as annual debt service). I'll present a simple example below:

Year 1
Income - $30,000
Expenses - $10,000
NOI = $30,000 - $10,000 = $20,000
Annual Debt Service = $10,000
FCF = $20,000 - $10,000 = $10,000

As you can follow above, we've calculated our NOI as $20,000 and our FCF as $10,000. Our example is for one year, for a full analysis we'd replicate for each year of the deal. Once we have cash flows for each year of the deal, we can easily calculate equity multiple, cash on cash return, and internal rate of return (I'll save those for another article). 

I'll note that we're estimating future performance, so income and expense numbers are based on extrapolations of past performance provided by the seller, or sometimes dollar per square foot numbers from market data. 

Finally, the calculations from our example represent a year of operation. In the life of a deal there are also two major income/expense events: acquisition (purchase), and exit (sale or refinance). Estimating expense or proceeds from those is the last step to building out your estimated yearly cash flows and being able to calculate your return metrics. But all of that good stuff is beyond the scope of our discussion today. I want you, the reader who's ready to start their investor journey, to walk away from this article armed with the knowledge that when it comes to analysis, it all starts with a couple numbers - your Net Operating Income and your Free Cash Flow.