Beginner Guide: Learn the Fundamentals of Real Estate Investment Analysis

David Cohn
Jul 16, 2021

Learning how to analyze a property’s financial details is the cornerstone of successful real estate investing. You should be able to recognize if a property is truly a good deal or a money pit.

In this guide, we’ll talk about how to perform real estate investment analysis on one of the most popular types of commercial properties available to beginner investors: multifamily rentals.

Read on to learn how to know if the multifamily building you want to buy is a viable investment in the long run.

Defining ‘real estate investment analysis.

Property investment analysis refers to the process of scrutinizing investment opportunities in order to determine whether or not they can produce your target profit and help you achieve your goals as an investor. It is one of the most crucial skills you need to possess to make money in property investing.There are four basic steps to analyzing the investment potential of a multifamily rental:

  • Property valuation
  • Calculating costs and expenses
  • Determining market rents
  • Calculating the return on your investment

While these four steps might seem simple, they take a lot of work. So let’s talk about each step.

Step one: Property valuation

This step essentially involves determining the investment property’s fair market value.

As you already know, sellers will always want to sell at the highest price they can get to maximize their profit. But your goal as an investor is the opposite—you want to buy the property at its fair market price or lower. Therefore, property valuation is crucial to ensure that you are not overpaying.

This is where comparative market analysis comes in. To start, look for comparable properties (known in the world of real estate investing as ‘comps’). In this case, you have to look for similar commercial multifamily properties in the recently sold area and share similar characteristics with the building you’re interested in.

How much did those comps sell for?

The answer will give you a hint about whether or not the property you want to purchase is fairly priced. In addition, it allows you to gauge how good or how bad the property is when compared to the overall performance of similar investment properties in the same locality. After this, you also have to determine the building’s income potential.

Unlike single-family homes, larger properties like commercial multifamily buildings are valued based on how much similar buildings sell. Their value also rests on the rental income they generate. Therefore, a property’s income potential has a dramatic impact on how much it is worth.

Step two: Calculating operating costs

All investment properties come with expenses that ultimately affect their profitability. Therefore, it’s important to factor in these costs to get a clear idea of how much you can expect to gain from the investment.

This is why the second step in real estate investment analysis is to do the math on the building’s operating expenses and other costs, including the following:

  • Principal and interest payments
  • Property taxes
  • Marketing fees
  • Insurance
  • Property management fees
  • Utilities
  • Maintenance expenses
  • Turnover costs

Most sellers are able to provide Pro-forma data. And while you should certainly look at this information, don’t base your decisions entirely on it. Keep in mind that the seller is motivated to sell you the rental property for a high price. It’s never wise to assume that everything they say is accurate. For example, they might ‘forget’ to mention certain operating expenses. They might also provide high rental income estimates.To protect yourself, it’s best to request actual data on the operating expenses and rental income in the form of documents such as:

  • Property tax bills
  • Tax returns from the previous years
  • Maintenance records
  • Other such information

You can look at the Pro-forma data side by side with the actual data to put yourself in a better position to determine whether the property is a good investment. This step is a critical part of due diligence before purchasing any investment property because it helps minimize your risks of running into surprises later on.

Step three: Determining the overall market rent

The third step in real estate investment analysis is determining the overall market rent so you can have a clear picture of how much rent you can expect to receive from the investment.

It’s important to consider the rent you will be charging your tenants upon acquiring the commercial multifamily property. Ideally, the rental income generated by the building should not only cover its operating expenses but also yield reasonable profits.

One of the simplest ways to determine market rent is to simply ask other investors and landlords in the area where the property is located. You can ask property managers and real estate agents for this information, too.

In addition, you can find and analyze rental comps to see what similar multifamily properties are renting for. There are also some online tools that you can use to see the average monthly rentals in certain locations.

Step four: Calculating the return on your investment

Now that you’ve gathered all the basic information you can about the property, it’s time to put them all together and determine whether or not it makes financial sense to purchase that multifamily building. There are several types of return on investment (ROI) you can look at for property investment analysis. Here are three of the most important:

  • Cash flow – This refers to how much money will be left after all expenses, interest payments, and principal payments have been paid. Real estate investors need to compute for this metric to ensure that they’re buying a rental property with a positive cash flow—something that will actually make them money. Be careful to account for all costs and expenses when doing the math on the property’s cash flow.
  • Cash-on-cash return – This is essentially a comparison of how much cash you get back vs. how much money you invested in the multifamily building. Be sure to factor into account your down payment, repair costs, closing costs, etc. It’s crucial to determine the cash-on-cash return because this metric shows you whether or not you have money left over to pay the bills.
  • Cap rate – To compute for this measure of ROI, simply divide the property’s net operating income by its current value. The cap rate is a good metric for quickly determining market trends, comparing several similar properties, and identifying risk levels associated with the investment you want to make.

Each of these three metrics for determining ROI gives you a clearer picture of a rental property’s financial viability. Make sure to account for all of them as you do your investment analysis. Don’t make the mistake of basing your decision on just one metric.