Essential Steps for Property Investment Analysis and Evaluating Investment Properties

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An investment property or rental property can be a great way to generate cash flows through rental income, provide asset appreciation opportunities and enable diversification. But before you put down the down payment or cash to purchase an investment property, make sure to do a thorough due diligence. Conducting a property investment analysis will help ensure you choose the right asset and know how to analyze a rental property thoroughly before committing.

There are several important real estate criteria to evaluate investment properties.  

• Financial metrics
• Market analysis
• Property analysis: Physical and legal inspection
• Property management
• Insurance

Financial Metrics

The goal behind buying investment property is to achieve a good investment return, generate cash flows, and diversify risk by investing in different asset classes. Therefore as a first step, do a rigorous analysis of expected returns and cash flows from a property. These financial metrics are critical components of any property investment analysis and are part of the broader real estate criteria used to assess whether a rental property is worthwhile. When conducting a property investment analysis, it’s also crucial to consider financing options and debt strategies. 

1. Return on Investment (ROI)

The Return on Investment (ROI) is a measure of the profitability of the property as a percentage of the investment value.  

The ROI is computed as follows

• ROI = (Gains -Cost)/Cost

Gains include:

• Rental income from property
• Appreciation on the property

Cost includes:

• Purchase Cost
• Renovation costs
• Ongoing expenses, such as maintenance, insurance and property management fees.

2. Net Operating Income (NOI)

Net operating income is the total revenue from a property minus the operating expenses. To accurately calculate rental income and net operating income, you should account for all possible revenue streams.

Net operating income = Annual Income from the property – Annual operating expenses

• Revenue comes from rent, laundry, vending machine, parking or any other income sources from the property.
• Operating expenses include maintenance, property management, property taxes, utilities and janitor & upkeep services.

3. Capitalization Rate

• The capitalization rate is the Net Operating Income as a percentage of market value of a property.
• A lower cap rate shows that a property indicates a higher market value of a property and lower levels of risk.

4. Internal Rate of Return (IRR)

• IRR is a measure of the return earned on the investment into a property. 

It is calculated by the following steps:

• Estimating the positive and negative cash flows of the investment over the holding period for the investment.
• The IRR is the discount rate that makes the net present values of all the cash flows equal to 0.

Comparables

Look at comparable properties or ‘comps’, which are similar properties situated in the same area. Evaluate the price of these properties and rental income and use these in your financial calculations.

Market and Location Analysis

• Demand analysis: Research the location and the investment market by looking at rental demand and potential rental values.  You may also want to look at resale values to ensure that you maximize property appreciation. 
• Vacancy & absorption rates: The vacancy and absorption rates in the neighborhood for similar properties can tell you about demand and pricing for similar properties in the area.
• Local economy analysis: Look at statistics for jobs and employment rates, local economy, crime rates. These will all impact the rental values and also future property values.  

Some investors even explore house hacking strategies to reduce housing costs and increase overall ROI.

Property Analysis

Physical inspection

When learning how to analyze a rental property, a thorough physical inspection is important in order to assess the building and land that it is sitting on. Hire a property inspector to thoroughly evaluate the property’s structural foundation, plumbing, electric and fittings conditions and pest situation.

Structural foundation

• Assess structural integrity including the foundation, roof conditions or damage, wall cracks and overall stability of the structure.
• Fittings: Evaluate the plumbing conditions, electrical and other fittings, air conditioning and heating systems. Look at the paint, windows, door conditions.
• Pest situation: check for pest infestation including termites, rodents, etc.

Legal evaluation

Legal property evaluation should include a title search, zoning laws, contractual review, environmental assessment. Also make sure to look at landlord tenant laws and rent control laws in the area you plan to buy.

Property Management

Think about whether you want to or will be able to manage the property yourself, including collecting rents, finding tenants, and maintenance and upkeep. If you are not fully comfortable taking this on, you can find a property management company, who will take about 10% of the rental income in return for taking all these tasks off your hands.

You can find a property manager through referrals, online reviews or an internet search. Read their contract and agreement, and also try to inspect the properties they are currently managing to evaluate whether their work is up to standard.

Also make sure to factor in the property management fees in your ROI or IRR calculations to ensure that the property is still worth purchasing after all these expenses are factored in.

Insurance

You will need landlord insurance that covers the property, including property damage, including fire damage, storm damage, lightning, wind, hail and also provides coverage for personal liability.

Conclusion

Screening and evaluating an investment property is a multi-step process. It involves financial analysis of key metrics such as ROI, IRR, and capitalization rate. A potential buyer needs to do an in-depth market analysis including rental demand and resale values, vacancy and absorption rates, and learning about the local economy. Thoroughly inspect the property for structural and physical damage and inspect the title and other legal documents. Finally ensure that you are adequately covered with insurance for the property and liability. Real estate investing can be a powerful tool for those seeking financial independence. Learn more about how real estate investing fits into an early retirement strategy.

At Planwell, we are building a fully automated AI financial planner and advisor that will allow you to evaluate real estate investments as part of our financial planning functionality to help you make super personalized financial decisions such as real estate investing, home affordability, financial independence and kids’ college. 

We will be launching the product in the coming months. Stay tuned for an update. In the meantime, check out our blog posts to help you plan your finances.

• House Hacking: The complete guide to house hacking. 
• How to Buy Your First Investment Property: A step-by-step guide to buying your first investment property. 
• How much of your net worth should be in your home? Figure out how much of your net worth should consist of real estate and how much should come from other investments such as stocks, cash or alternative investments. 
• Nominal vs Real Interest Rates: Learn about how nominal and real interest rates are used for financial planning. 
• How to retire early and achieve financial independence: Tips to retire early and achieve FIRE (Financial Independence, Retire Early)
• How to build a personal financial plan: Before you make a home purchase, make sure to build your personalized financial plan with our 10 step guide.