Financial analysis of the property
It is critical for a potential buyer to conduct a proper financial analysis before making a real estate purchase, no matter what the purpose of use of the property is. Information will give you greater negotiating power and the more information you have the better.
What information do you need for financial analysis? In general:
- Property value (including cost of repairs if necessary)
- Estimated operating expenses detail
- Estimated rental
- Estimated property occupancy rate (or vacancy rate)
- Loan amount, interest rate, and credit term if not paid in cash
On the expenses side, the most common are:
- Property tax
- Third-party property management fee
- Property insurance
- Maintenance & repairs
- Property depreciation
- Mortgage interest
- HOA (if applicable)
- Basic services
With the property information you can calculate:
- Cash flow
- Profitability
- Other financial ratios of interest such as investment/rent and the 1% rule (there are many and these are just an example)
Property cash flow represents how much money you have left from your rent after you have paid the property expenses and loan payment. It is calculated as follows:
Cash Flow=Net Operating Income (NOI) – Loan payment
Where,
Net Operating Income=Rent-Vacancy-Property tax-Management fee-Insurance-Maintenance & Repairs-HOA-Basic services
On the other hand, total cash flow is calculated as:
Total Cash Flow=Cash Flow-Accounting services-Taxes (income, estate, capital gain)
It is convenient for the investor that both Operating Profit and Total Cash Flow be positive. Many investors use these savings to cover the expenses of the property when is not rented, to cover unexpected repairs, among others, so it is always recommended to maintain a minimum positive balance in the property bank account.
As for profitability (return), the first step is to understand that the total profitability of a property comes from 2 sources: profitability of rental cash flows + profitability from the appreciation of the property. As with cash flow, the investor should look for positive returns and the higher the value the better.
Return=Return on property appreciation+Return on rental cash flow
Return on property appreciation= Current value of the property/Purchase price -1
It should also be included in the analysis the non-economic aspects that influence the appreciation of a property. For example, neighborhood, proximity to public transportation, schools in the sector, shopping centers, housing developments and new industries in the area, etc. are some of the factors that could accelerate the appreciation of the property in the future.
The profitability of rental cash flows can be calculated in several ways. One of them widely used in the industry that has the added benefit of being independent of financing as it focuses exclusively on the return of the property, is the Capitalization Rate (Cap. Rate). It is a measure of the rate of return on a property given an initial investment. It is calculated as follows:
Capitalization Rate=Net Operating Income (annual)/Property Value
Capitalization Rate=(Rental income-Vacancy-Property tax-Management fee-Insurance-Maintenance & Repairs-HOA-Basic services)/Property Value
With the seller’s price plus the estimated rent and property expenses, it is possible to calculate the capitalization rate. For example, if the capitalization rate is lower than the market rate, you can negotiate a lower price to match it, and if you are looking for a higher target return than the market rate, you can calculate up to what price to offer to obtain it. Fortunately, Real Estate Financial Intelligence S.P.A. does the work for you, and you’ll have access to up-to-date market information. Always remember that information is power!
Other interesting financial ratios to include in the analysis are the price-to-rent ratio and the 1% rule.
The price-to-rent ratio is a measure of the relationship between the property value and its annual gross income. As a general reference, if the resulting number is greater than 12, then the property is expensive. Of course, this is an arbitrary number and can change depending on market conditions. The calculation formula is:
Price-rent ratio=Property Value/Annual Gross Income
Another quick and easy ratio is the 1% rule. The ratio indicates that the monthly rent should be at least 1% of the property value (including repairs). That is, if the property is worth $100,000 then the gross monthly rent should not be less than $1,000.
Monthly rent ≥1%*investment amount
However, in the current market of Florida, it is not surprising that instead of 1% this number tends to be lower, just like the price-to-rent ratio tends to be higher than 12.