To understand if a real estate investment is right for your portfolio, an Investment Analysis should be performed. Investing in real estate is very similar to investing in stocks, bonds, and other assets.
As such, it’s important to know whether the investment is actually an asset to you; too often bad real estate investing decisions prove to be liabilities, especially without proper research of the investment. The process of analyzing the risk and profit of an investment will provide you with a better idea of whether you should invest or find an investment alternative for your portfolio. During the process, three factors will be assessed: risk, capitalization rate, and resale value. Here is what each step of a real estate investment analysis looks like.
Step One: Evaluating Risk in your Real Estate Investment
Whether you are seeking a residential or commercial real estate investment analysis or any other investment analysis, evaluating your risk should you decide to invest is important. Simply said, if your investment property risk is too great, loss is likely. This is the first step because without knowing your investment risk, cash flows and resale value matter little if the investment real estate is worth nothing. Even after calculations, the risk is not a definite factor. Other things related to the potential investment are the market, industry, and more. In real estate investing, environment and location should be analyzed deeply. Location is everything when evaluating real estate investment risk. It can tell you a lot about the long-term value of your property, which is vital when investing in real estate.
Should You Proceed?
Knowing your real estate location, environment, and other factors of your property investment will help you better understand whether or not you should proceed with the investment analysis. Prior to making any more decisions on the analysis, once a real estate investor has chosen a specific location for his or her investment property, this location and any aspects of it that could affect the property value and its performance must always be taken into consideration. For example, if a real estate property is located in an area that experiences warm weather in the summer and cold weather in the winter, a seasonal approach should be taken when planning the overall investment strategy. This will determine the results of the next step of your investment analysis; knowing how to structure your property’s performance will be greatly based on your goals for it. Are you planning on renting it to vacationers? If so, you should understand that a property, as described above, would decrease in cash flow in the winter months when sun-seeking vacationers are less likely to rent out your property. This could be determined to be a risk that could affect your overall property value.
Step Two: Value in your Real Estate Investment
There are many important numbers to consider when evaluating the value of your property investment.
- Mortgage payment
- Down payment requirements
- Rental income to qualify
- Price-to-income ratio
- Price-to-rent ratio
- Gross rental yield
- Capitalization rate – one of the most important assumptions to make when valuing property
- Cash flow – cash flows equal repayment on your real estate investment and the estimated value of risk, as determined in step one.
Two of the most important metrics above are capitalization rate (cap rate) and cash flow. These two metrics determine how much money you will make less your risk estimation and how much money you will make less your operating expenses. The capitalization rate can be estimated by beginning with the annual rent total of the property and subtracting annual expenses, then dividing that number by the total property cost. Total rental property expenses include any probable repair costs, taxes, landlord insurance, vacancy costs, and agent fees. There are multiple methods that investors can use to find an appropriate capitalization rate.
- The Build Up Method – The advantage of this method is that it’s designed to accurately measure individual components of a discount rate.
- The Market-Extraction Method – The advantage of this method is that the capitalization rate makes the direct income capitalization more meaningful.
- The Band-of-Investment Method – The advantage of this method is that it is the most appropriate capitalization rate for financed real estate investments.
It’s a vital step in investment evaluation to know your cap rate in a commercial real estate investment in order to make your investment back and assume your anticipated risk.
Step Three: Evaluating Future Resale Value
Should you ever wish to sell your investment properties, you’ll want to know your resale value. Measure the expected rate of growth on the investment real estate to ensure that the value of this and any related cash flows are more than the loss of investment and the estimated risk.
With all of the steps that occur during the process of investment analysis, you can feel comfortable in making a decision to add the property investment to your portfolio or forego the investment and seek investment alternatives that come out more return-on-investment positive in an analysis.
Contact Ferstl Valuation Services today
For help understanding if your investment opportunity is a good addition to your real estate portfolio, contact our professionals today. We’ll help you determine how to add real estate to your portfolio and make it profitable. Because property markets are less liquid and clear than the stock market, it can be a daunting task to obtain the information required to make a completely informed property investment decision. However, because of the size of the investment typically required to purchase an investment property, this complicated investment analysis can vastly pay off if it stops you from unknowingly investing in an undervalued property and losing large sums of money. Hiring Ferstl to help you with your property investment analysis will prove to be a valuable decision. Give Ferstl Valuation Services a call today to get started on your real estate investment analysis.