A BASIC APPROACH FOR ANALYZING AN INVESTMENT PROPERTY

Although there are many ways to analyze an investment property, the following is a basic and simple methodology that can be utilized by many investors.  Bear in mind that this is not the only approach nor should it be the only type of analysis that is undertaken. Investors should also analyze market data (vacancy rates, occupancy rates, location, sales and rental comparables, etc.), consider the investor’s requirements, objectives and finances, and utilize other sources of information, data and analytical tools.

OVERALL FINANCIAL RETURN

The Overall Financial Return is the financial rate of return, expressed as a percentage, of the property’s net income[1] based on the total purchase price.

Example:

Property A has a net income of $10,000.  The total purchase price is $100,000.

The Overall Return is 10.0%[2]   (10,000 / 100,000 = 10.0%)

 

CASH INVESTMENT RETURN

Typically, investors have a limited amount of cash or “equity” that they have available or are willing to invest in a property. As a result, the investor provides cash (e.g. 20-25% of the purchase price)[3] and usually gets the rest of the funds via a mortgage loan.

The Cash Investment Return is the financial rate of return, expressed as a percentage, of the property’s cash flow[4] based on the actual amount of cash or equity that an investor contributes to the purchase price.

Example:

In the Property A previously stated, the investor provides $20,000 (cash/equity). He or she obtains $80,000 for the purchase via a mortgage loan. Let’s assume the investor obtains an $80,000 loan[5] and the annual mortgage $6,877. The cash flow is $3,123 ($10,000 net income minus $6,877 mortgage payment = $3,123).

The cash-on-cash or equity return is 15.6% ($3,123 / $20,000 = 15.6%)

 

In many cases, but not always, the use of leverage (using some other source of funds) can result in a higher financial return than if the investor purchased the property with 100% of his or her cash or equity.

[1] Net income is the property’s income after you deduct operating expenses but before deducting mortgage payments, if any, and income taxes.

[2] The Overall Return Rate is also known as a “Capitalization or “Cap” Rate”.

[3] A lending institution, such as a bank, is typically willing to provide a mortgage loan for approximately 80% of their estimate of the property’s value which may be higher or lower than the purchase price.

[4] Cash flow is the property’s net income less any mortgage loan expense (but before paying income taxes)

[5] Assumed 6%, 10 year, 20 year amortization.

[1] Net income is the property’s income after you deduct operating expenses but before deducting mortgage payments, if any, and income taxes.
[1] The Overall Return Rate is also known as a “Capitalization or “Cap” Rate”.
[1] A lending institution, such as a bank, is typically willing to provide a mortgage loan for approximately 80% of their estimate of the property’s value which may be higher or lower than the purchase price.
[1] Cash flow is the property’s net income less any mortgage loan expense (but before paying income taxes)
[1] Assumed 6%, 10 year, 20 year amortization.