How to know if it’s a good investment? Part 1
If you are purchasing an investment property, you will want to perform a financial analysis to determine if it is a good investment. A good investment is a comparison to other investments similar or different that proves to show a positive cash flow or increase in value over some time.
Let's consider a six-unit multi-family investment property I have for sale on Randolph Street in Napa. Is this a good investment? How does it compare to other multi-family investments, other real estate investments, and different types of investments such as stocks, bonds, or CDs?
Let's work on simplifying the various steps to analyzing investment real estate.
Objectively determining the market value
The income produced from an investment property directly affects its market value. Generally, the rent less the operating expenses gives us the income. If the rent increases typically, so does the value. If the expenses increase the value decreases.
Several other factors could also affect the market value, but that discussion is for another article.
Appreciation is a perceived increase in market value that some may consider in their analysis, but it could be challenging to determine and is affected by the location and economy.
I like to think of appreciation as being reflected in annual rent increases. It is essential to keep pace with inflation, but rent values are also an indicator of the local supply and demand as well as the overall local economy.
Some investors may purchase an investment purely for potential appreciation and may even accept a negative cash flow in the interim. Unless there is a specific reason for the appreciation such as rezoning or the pursuit of entitlements for a particular use, I would consider this method of determining value as speculative with potential pitfalls.
Cash flow is king
In a previous article, I talked about the proforma analysis. There exists the seller's financial analysis that represents how the investment is currently performing. Then there is the buyer's analysis that would represent changes which occur when a buyer purchases a property.
Some of the changes could be new financing, an increase in property taxes, and possibly reduction in expenses if the buyer secures new vendors or negotiates services.
The buyer's proforma analysis goes one step further representing what rents and expenses could be with some work. My analysis of the Randolph property is a proforma analysis because many of the rents are below market rent.
The proforma potential rental income (PRI) of the Randolph property is $127,200 per year. This rent could be attained partially by just increasing rents. However, some of the units do need updating and can garner this level of rent after that.
PRI less a vacancy rate of five percent gives us an effective rental income (ERI) of $120,840. Being there is no other income such as laundry or parking fees to add in, the ERI is our gross operating income or GOI.
In the next articles, we will discuss expenses of the Randolph property, how a loan fits in, and what all the different financial indicators represent.
Burt M. Polson, CCIM, is an active commercial real estate broker. Reach him at 707-254-8000, or firstname.lastname@example.org. Sign up for his email newsletter at BurtPolson.com.