Real Estate Financial Analysis

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Real Estate Financial Analysis

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Last Updated:August 18, 2023

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Real estate is the largest asset class in the world and has consistently seen an increase in new investors. Therefore, if an investor is considering investing in real estate or becoming a real estate broker, it is essential that they understand the asset class and how to analyze it.

Real estate itself falls under a more significant asset class referred to as the alternative asset class, as it's an alternative asset to owning a business's equity or debt (stocks or bonds). As a result, real estate can add a quality asset to your portfolio while assisting in diversification.

There are new as well as traditional methods of investing in real estate. Some equity crowdfunding sites, such as Fundrise, let investors buy shares of a property. Some corporations use crowdfunding to acquire a new singular property, such as offerings on Equivesto.

Some REITs function as a hybrid between a stock and real estate. These tools offer an equity stake in a publicly-traded company that owns real estate income properties and has unique conditions to benefit the shareholders.

There are many perspectives to undertaking real estate financial analysis, especially when considering all the different ways to invest in real estate. However, for this article, we will focus on the most traditional form of real estate, buying an income property directly.

How does real estate financial analysis work?

Real estate finance itself can be a vast and cumbersome topic. There is the investing side (similar to the buy-side) and the lending side (similar to the sell-side). For our analysis, we will focus on analyzing real estate as an investment on the buy-side.

When analyzing real estate, you want to understand the property type before investing. Not just that, but there are also a few crucial components and considerations between metrics and property types one should understand when investing in this asset class.

You can analyze real estate under three main components:

1. Analyzing cash flow

Cash flows can be the net cash flow, cash flow to loan value, etc. But the bottom line is understanding the cash that the investment property can generate is essential to investors.

2. Tax effect on income

Investors want to know their take-home pay. But first, the investor should understand the tax implications of investing in real estate. Is the particular investment tax efficient? Is it worth investing in after taxes?

3. The net benefit of owning the property in the future

Investors can also attempt to understand the after-tax benefits of owning property. That includes capital gains and discounted future cash flows less annual expenses to be covered.

Investors should analyze the quantitative metrics of owning a property to determine its fair value, as these components are the fundamental financial metrics for investors to consider.

The three considerations for investors revolve around these unique characteristics of real estate:

Real estate is a long-term investment for most. While some individuals choose to speculate on real estate, investors can also generate income by holding onto properties and renting them over the long term.
Compared to other alternative assets, real estate lacks liquidity, thus increasing the importance of understanding cash flows. You can count on the cash flows in the long term, but it is hard to liquidate the property quickly in adverse market conditions.
The changing environment can primarily affect how attractive real estate is at a given moment. While those invested in real estate are pretty locked in, those considering adding their capital to the market can be sensitive to specific market aspects such as:
- Economic conditions
- Recent real estate pricing changes
- Central banking rates
- Other conditions that materially affect one of the three components of real estate analysis

If this all seems like a lot, this is a worthwhile comparison that might aid in understanding real estate financial analysis. Many real estate fundamentals are similar or alternative versions of analyzing stocks.

It is essential to understand the asset itself, though. Just like analyzing companies, it is crucial to analyze comparable assets. You should compare similar properties and markets to understand if individual properties are suitable investments.

For example, a 4-unit multifamily property differs from a 20-floor office building in tenant numbers, tenant types, initial investment size, geographic location, upkeep, market demand from buyers versus renters, etc.

Property types are valued differently, but residential property prices are closely correlated to market conditions. At the same time, commercial real estate is more correlated to income generation potential and the specific financing available for each property.

For example, single-family units are more closely subject to market demand since investors compete with owners and like-minded investors planning to live in those units.

Meanwhile, an office building will be more correlated in value to cash-generating potential since it is primarily bought by those who consider it an investment for income.

Comparisons could even come down to what side of town the property is on that determines the fair value of a property. One side of the analysis is gathering information on characteristics such as the offer price, size, and type of similar properties.

On the other end of the analysis, investors should consider market analysis for real estate in determining the quality of an investment.

Once the investor gathers information, they will proceed with the financial analysis of the property.

Gathering information for real estate financial analysis

Too often, investors will buy a stock without conducting sufficient research on the company. Unfortunately, real estate is not all that different, as people can quickly deploy capital into an investment property without first researching and comparing one property to another.

The information and where to collect this information are all essential preliminary steps to analyzing a real estate investment opportunity.

1. Property details

Property details include things such as:

The number of units on the property
The square footage of the property and any buildings on the property
Utility pricing for the area or records of utility costs are even better
Other direct costs of operating the property

You check with the seller or the local records office to find the information. The local records office will be good for finding zoning info and property lines. The seller will provide floor plans and general building information if they have those records.

The company offering the service can provide any other costs, utilities, rates, etc.

2. Purchase information

Purchase information includes:

Immediate expenses of buying (example: lawyers, renovations, other closing costs).
Renovations and improvements made before renting/leasing

A property inspection is best before buying a property; the property inspector can raise any concerns and make both parties aware of the condition of the building. Thus, a preliminary assessment can aid in estimating a more accurate value of the building and avoid any surprises for the buyer.

3. Financing details

This information includes:

Mortgage and loan rates
Total loan amount
Downpayment
Closing costs

Before closing the deal, you can discuss the financing details with the lenders or mortgage brokers. They should be able to provide all the numbers required to analyze this aspect of the deal.

4. Income generated by the property

Includes:

Any income already generated by the property

You might consider sourcing this from the seller. However, you can also consult the property manager to confirm if the numbers are accurate.

5. Expenses

Expenses include:

Maintenance costs
Property tax
Property insurance

The seller might be able to estimate regular maintenance costs. If there is a property manager, discussing expenses with them might also help. Lastly, the property inspector might have some insight into upcoming maintenance expenses needed on the building.

The important aspect of gathering information is ensuring it is complete, detailed, and high-quality information. In some cases, you may have to rely on the sellers' words, but it is essential to the seller that they positively present information.

It is also worth considering the timing of the gathered information. For example:

Old floor plans might not include renovations and additions.
Old property value assessments can mean the property will be revalued by the government, changing the property tax amount.

After gathering sufficient information, investors can now move on to analyzing the value of a property.

Real estate financial analysis metrics

Real estate closely resembles the qualities of a good dividend stock. There is a reasonable expectation of income, although it is not guaranteed, and the asset may also appreciate, and real estate financial analysis takes both these factors into account.

To keep this section organized, we will divide up the various calculations into three segments:

Income and expenses
Property performance
Valuation

Income and expenses relate to the various costs and sources of income a property generates. It's not just rental income; properties can generate cash in multiple ways. The same goes for expenses, which are more than just the mortgage and utilities.

Property performance relates to the various ways the performance can be measured - Pre-interest, post-interest, income vs. value, etc. If there is a question of measuring a property's performance under specific considerations, there is probably a metric to answer.

Lastly, how is property value determined? It is sensitive to both market sentiment and property income generation potential. Being able to estimate what price to pay for a property is a significant figure to assist in protecting the capital of investors.

Once you gather all the relevant information, analyzing a real estate investment becomes easier. However, keep in mind that this is a general guide, and you need to account for specific considerations of different property types.

Income and expenses in Real State Financial Analysis

These metrics will focus on taking the total rental income, categorizing, organizing, finding the total expenses, and taking the difference to figure out net operating income or NOI.

Step 1: Finding gross income

Once you calculate the number and the income each unit generates, finding gross revenue for a property becomes a simple matter. Add up the monthly rent for each unit to see total monthly revenue, and multiply by 12 to calculate gross annual revenue/income.

Other sources of income might include parking spaces, storage, and laundry services. Again, these may be small compared to the income generated by rent. Still, for units taking advantage of these services regularly, this could significantly increase the total annual revenue of those units.

Step 2: Managing expenses

At this stage, investors must find each of the following expenses. The total costs will be crucial to finding the NOI (net operating income).

These expenses include:

Insurance
Management fees
Utilities and amenities
Repairs and renovations (occasionally referred to as CAPEX depending on the type of expense)
Advertising
Landscaping
Property tax

Some of these expenses, such as insurance and utilities, will be regular occurrences. However, some costs, such as repairs and advertising, pop up more sporadically. Therefore, if possible, it is best to form a budget based on historical figures for these expenses.

You can further break down expenses into costs per square foot. It helps estimate the average cost per unit. Then, taking the total expenses, you can divide it by the total square footage of each unit and, from there, assign an expense estimate per unit based on size.

Step 3: Calculate net operating income

Net operating income is an essential metric for real estate financial analysis, which measures the performance of the investment. Net operating income is the total or gross revenue less the total expenses.

You can calculate the net operating income as:

Total NOI = total income - total expenses
NOI per unit = (total income - total expenses) / # of units
NOI per square foot = (total income - total expenses) / total square footage of rental units

Performance-related metrics (including capitalization rate)

These metrics are focused on what the property will return to the investor. They encompass how much the asset returns compared to its value, the cash generated by the asset, and the rate of return the property gives after financing.

These metrics include:

1. Cash metrics

Cash flow
CoC Return (Cash on cash return)

2. Return on investment metrics

Rate of return
Total ROI

3. Capitalization rate

Breaking each of these metrics down can be very important for considering a variety of factors that you must consider before investing.

Cash flows are essential for individuals or institutions that need a property to be cash flow positive. For example, perhaps the fund is small, or the buyer is highly leveraged and needs to ensure a positive cash balance at the end of the month as buffer room for expenses.

For cash on cash, you might want to compare properties and see which have higher expenses than the cash flow they provide the investor.

Outside of the individual's circumstances, investors may question whether the real estate investment is intrinsically valuable. For this concern, investors might consider analyzing a rate of return and comparing it to other assets with similar risk levels.

If you can generate better returns at the same level of risk, many investors would consider that valuable information.

Lastly, the cap rate is one of the most critical real estate financial analysis metrics. Does the property's gross income, less operating expenses bring in good returns?

If EV / EBITDA is a powerful metric for evaluating companies, then the cap rate and everything you can do with it is like the real estate equivalent.

Cash Metrics in Real Estate Financial Analysis

The cash metric comprises:

1. Cash flow

Cash flow represents the cash left for the owner after expenses. The critical difference between this and NOI is that NOI measures how much the property generates. Therefore, cash flow is what an individual investor might receive.

In other words, NOI can be used to compare various properties and provide the attractiveness of an investment, regardless of the individual investor.

On the other hand, since cash flow also takes out debt, it can help determine an investment's attractiveness, considering the individual investor's decision and history.

If the investor decides to pay more upfront, the cash flow will more closely resemble the NOI and vice versa. On the other hand, if the investor has a good credit history, this will also reduce the financing costs and move cash flow closer to NOI.

If you acquire the property in an all-cash deal, then cash flow and NOI will match exactly.

2. Cash on cash return (CoC)

Cash on cash returns is yet another way to measure the performance of an investment property. This specific metric will analyze a rate of return against expenses, including the cost of financing.

This specific metric will also consider your return relative to other factors, such as how your returns stack up close to the downpayment size. With all these factors stacked together, this is a compelling investment performance measurement.

CoC return = cash flow / investment basis

Cash on cash return is also a great way to consider an investment property's bottom line earnings rate against another asset, such as stocks. Depending on how risky an individual property is, you may require a rate of return equal to or slightly above/below the average stock market return.

Return on investment metrics in Real Estate Financial Analysis

The return on investment metrics comprises:

1. Rate of return

While it is essential to know whether the asset is cash flow positive, it is also worthwhile for investors to consider what additional income the investment generates compared to other assets by factoring in risk and relative return.

Rate of return (a.k.a. Return on investment or ROI) is how an investor can analyze the performance of their risk asset against other investments.

With the information we gathered, we will need to bring together the cash flow metric we just found and the total expenses to purchase the property, also known as the basis. Then, we can use the following formula when trying to find ROI.

ROI = cash flow / investment basis

This formula will provide a percentage of return against our initial investment. How does an investor determine if the property is a good investment? This will depend on the leverage used to buy the property and the current macro environment.

Generally, investors may target somewhere between the stock market rates and some form of risk-free (or relatively risk-free investment).

An investor might look at savings account rates, often less than 2-3% on the less risky end. In addition, investors may look at other low-risk options, such as treasury bills and central bank lending rates.

Slightly more risky assets such as GICs and CDs will often sit at the central bank rate plus a few pips.

Some stocks have historically returned between 7-10% on the higher end of risk.

Real estate investors might target the risk-free rate and the rate of return on equities. Still, in recent years real estate has appreciated at such a rate that investors have been willing to take lower rates of return, at least on the residential end of the market.

2. Total ROI

One final performance metric that an investor might look at is the total ROI. The total ROI metric measures an investor's net benefit for owning a property.

The formula requires:

All expenses already accounted for
Capital gains, income, and other related taxes
Equity, the owner, has accrued
And property appreciation

Adding other taxes not accounted for will affect the bottom line for the investor. For example, it takes away the income taxes from the owner and capital gains tax or tax credits from depreciation, which will affect the net benefit of the property owner.

Real estate value also often appreciates over time. This will also affect the net benefit at the end of owning and eventually selling a property. The other use of an investment property is the rental income, which can be applied to the mortgage/loan and build up the owner's equity.

Projecting expenses and appreciation can be difficult, bringing investors back into the realm of art instead of science. The important part is that each factor is estimated or calculated as carefully as possible, but an estimate is better than ignoring costs altogether.

Anything affecting the bottom line must be considered, hence total ROI.

Extending analysis and ownership is vital for investors. Creating projections can allow investors to understand a good time to exit.

Holding the property over time also allows upfront costs to be broken up over an extended period, reducing annual expenses.

This can also be difficult as there are unpredictable expenses, and estimating inflation accurately over the long term can be difficult for any economist. But again, an estimate is better than ignoring potential costs altogether.

Capitalization rate

The capitalization rate, to some investors, is the most crucial metric when performing financial analysis on a property. Therefore, real estate investors use the capitalization rate as a raw analysis of a property's performance.

This metric is so great because it allows for comparability between various properties. These are the main benefits of using a cap rate.

Firstly, it is unaffected by individual financing costs. It simply provides a performance rate for the return on investment for a property without changing the rate based on financing costs. It is a property's pure income generation potential.

In other words, it is the ROI of an all-cash acquired property.

Second, this rate is a strong indicator for properties valued based on their income potential. Residential real estate is highly tied to the market's supply and demand curve, while commercial real estate is more closely priced based on capitalization rates.

Depending on size and location, certain types of commercial real estate are based on cap rates or metrics directly tied to capitalization rates.

Third, you can use the cap rate to derive further, and more insightful metrics, including:

1. The buildup method - estimating property value considering various financing costs

2. The market extraction method - involves using market values to estimate either property value or income that the property should generate based on its price.

3. The band-of-investment method - involves estimation similar to WACC and deriving a required rate of return and the estimated property value.

So how is the cap rate calculated?

Capitalization rate = NOI / property price

This can lead to rates depending on the individual property, current market conditions, and the property's perceived future income generation capabilities. However, the upper range of real estate capitalization rates typically sits around 8-12%.

Generally, once you find NOI and cap rate, you can also estimate property value.

Property value = NOI / cap rate

Property Value is essentially just reorganizing the capitalization rate formula to estimate value.

Buildup method

The buildup method will essentially combine the various financing rates and premiums associated with buying a property. Once you account for these rates, you can use the cap rate to estimate the property's value.

Step 1: Find the interest rate of the property. As mentioned, you can find this by contacting your mortgage broker or whoever provided the loan for the property if financed through debt.

Step 2: Estimate or calculate the required

Liquidity premium
Recapture premium
Risk premium

The combination of all these rates and premiums can also be considered the estimated required capitalization rate.

Step 3: Find the total annual income of the property.

Step 4: Take the total annual income of the property and divide it by the estimated capitalization rate the investor would require.

Once the investor has gone through all these steps, they should arrive at the final estimated value of the property.

This method works for many investors because some factors around real estate might not be quantifiable with the information an investor has presented.

This method allows the investor to fill in the blanks where needed or to use methods of calculation they believe are appropriate for the given level of risk. Investors must be careful with their estimates and understand that this is more art than science to navigate this metric.

Market-extraction method

Market-extraction method is an excellent tool for market information to aid decision-making. However, for this to work, the investor needs ready access to comparable net operating income and the selling prices of those similar properties.

With this information in combination with the cap rate, the investors can gain precious details regarding what the comparable cap rates and even intrinsic property values might be.

The method involves collecting the NOI rates of multiple properties and their current selling prices first. As with most statistics-based measurements, the more similar samples that can be collected, the better.

Taking an average of the cap rates [(NOI / price of the property) / number of samples], the investor can estimate the appropriate cap rate for that property type in that area.

To build on this, if there is an average cap rate available and NOI, then taking the NOI / average cap rate, you can then estimate the property's market value.

Band-of-investment method

This method provides an opportunity to compare properties with different rates of interest. For example, if financed by a mixture of debt and equity, you can compare these properties by their WAR (weighted average rates) to make worthwhile direct comparisons between properties.

To use this method, the investor must calculate the sinking fund factor.

First, contact your broker or loan underwriter, and figure out the rate provided to finance the property.

Next, you will calculate the sinking fund factor (SSF), the rate a property can be paid back while still earning enough to buy a new one or replace it by the end of its useful life.

SSF = interest rate / [(1+interest rate)n - 1]

The SSF plus the interest rate is the rate the lender must pay to make sure the property can be replaced on time.

On the other end, investors must calculate their required rate of return (perhaps using one of the already mentioned methods) to obtain a rate at which equity should earn interest.

Once the investor has determined this, you can calculate the weighted average rate of capital (equivalent to the cap rate required for the property).

WAR = weight of debt * (SSF + interest rate) + weight of equity * required rate of return for equity

WAR is similar to understanding the WACC of a company. With this metric, you can also make a property value estimation.

Market value of property = NOI / WAR

There are various ways investors can determine an investment property's market value. However, it should also be clear what the importance of the capitalization rate is due to its versatility and ability to provide a deeper analysis of property performance and value.

Valuation based metrics in Real Estate Financial Analysis

While we have already discussed ways to estimate property value, which is especially effective with the cap rate, you can calculate the fair value more effectively using various metrics.

Think about a football field graph. Providing a series of ranges can help the buyer ensure that the price they are paying is fair. Think of each additional measurement as an additional sanity check.

The different number of measurements has diminishing returns at some point, but sticking to what we provide is a good start. Investors will eventually work out what metrics they prefer and trust and they can drill down more accurate valuations with more experience.

1. Discount NOI

The discounted NOI is similar to the dividend discount model for analyzing stocks. The investor can discount future NOI by the net required return rate less than NOI's expected growth rate.

Market value of property = NOI 1 / (r - g)

This formula attempts to determine the intrinsic value of a property by directly comparing NOI to the net required rate of return.

2. Gross income multiplier

Compared to discounting NOI, the gross income multiplier allows for a beneficial relative valuation. This metric considers market conditions and rates to aid in valuing the property.

This does infer that similar properties close to each other will be valued similarly relative to their gross income.

The first step is finding vacancy rates. Essentially, this is the number of units that remain unoccupied over time. The investor will have to research, estimate, and project average vacancy rates in the local market.

Next, the investor will assume an average vacancy rate in their property (this works best for multi-unit properties). After subtracting the lost NOI caused by vacancy, the investor now has an expected NOI after accounting for the vacancy rates, which we will refer to as adjusted NOI.

Lastly, the investor will have to find the other prices and adjusted NOI of similar properties in the area or the average gross income multiplier.

Once we have all this information, simply fill in the following formula:

Property market value = average gross income multiplier / adjusted NOI

Equity investors might recognize this as a similar valuation method to spreading comps and analyzing precedent transactions. Instead of EPS and PE ratios, real estate calls for NOI per square foot and gross income multiplier.

In summary, we have covered what real estate financial modeling is. By following this article step by step, you can create a series of robust metrics to create an ideal property price range while understanding various income generation potential metrics.

The topic of real estate investing is ever-expanding, and it is essential to stay up to date on metrics in the markets you invest in.