Key questions to ask when analyzing a real estate investment
When purchasing a single family or multi family real estate investment based on pro-forma calculations for either short-term rental (STR) or long-term rental (LTR) use, the purchaser must always begin with the end in mind aka exit and income strategy. In this post we will go over the questions I ask myself and the answers I am looking for when analyzing a real estate investment. There are other key performance indicators such as internal rate of return but for simplicity purposes we will address the following questions.
Can I sell this property today at the purchase price which I paid today?
The answer to this question must be an unequivocal yes. At the very minimum I must be able to sell my newly acquired property for the price I purchased it for, in other words there must be a buyer waiting right behind me to purchase this asset. This is the true litmus test on whether I have made a good purchase. Ideally, I will buy this property under market value in order to capture equity upon purchase. The old saying goes you make your money at the time of purchase, so make sure you at least don’t lose money at time of purchase.
What will be the potential gross revenue once my investment is stabilized?
I must know the whole prior to knowing anything else. The first thing I need to know how much total revenue this investment will bring, only from there can I assess what potential profit will be. In order to know the whole I need to know the market and product quality. I would only gauge this investment based on LTR market revenue because that is my most conservative income estimate. It needs to make sense from a cash flow perspective based on LTR projections, STR revenue projections should be examined, but only as icing on the cake as not to influence my purchase price.
What are my fixed costs?
My fixed costs will include real estate taxes, insurance, allocation for capital expenditures and debt service (if any). These costs will be in place irrespective of anything else, no matter what they have to get paid. I have little to no control over these costs.
What are my variable costs?
My variable costs will include things like vacancy, utilities, repairs and property management. I have a higher level of control over these costs therefore I can try to reduce these costs to run a leaner more efficient investment property.
What will be the net operating income once my investment is stabilized?
A stabilized rental property is one that is cash flowing at full utility with little to no vacancy, at or above market rents with leases in place if LTR. This stabilized revenue minus fixed and variable expenses produces my net operating income. This investment should have revenue increasing and expense decreasing potential. This potential is an internal measure and does not affect my purchase price. Never pay for your own potential. The net operating income plays a big factor in determining future asset value.
What is my total investment?
Meaning time and money, if the property is turnkey I spend much less time and money after purchase to get it income producing. If the property needs renovation then I need to take renovation cost and time into account. The amount of time you spend plus the amount of money you spend will be the total investment, there is a hidden opportunity cost towards allocating time and money towards a specific real estate investment this cost varies per investor.
What is my return on investment?
This is the magic question, this factors in all previous questions. Return on investment is the net operating income over the total amount invested. Returns depend upon leverage, with healthy 75% leverage my cash on cash return should be about 12% or higher. I can go higher on non traditional financing to increase leverage but there is risk with higher more expensive debt which can appear if cash flow is adversely affected. Conversely, less debt will mean a lower return but also lower risk. I don’t like the risk proposition of an over-leveraged asset paying expensive interest costs therefore the investment should have stabilized rental income and no more than 80% loan to value at market interest rate.
What will be my return on investment if this operates as a short-term rental?
My STR revenue should be at least double LTR revenue for this investment to make sense. There are additional startup and operating costs when running an STR such as furniture, cleaning, supplies and higher utility costs as well there is the hospitality part of the STR which makes operations a bit more complicated than running an LTR. The net operating income should be substantially higher because of the headache I have to undertake to operate an STR. Theoretically, more headache should equal more profit but in practicality less profit equals more headache.
Always make an investment decision based on LTR cash-flow
Know your exit and income strategy
Thanks for your time and attention.