Analyzing Real Estate

by Clifford A. Hockley

Investing in real estate is a tricky business, and like the stock market, every investment will not be a great one. As a matter of fact, what makes a great real estate investment is keyed as much to timing and interest rates as it is to the true operating costs of a property.


I will grant you that every marketplace is different, and market conditions may force you into overpaying for a property you really want, but if return on investment is what you want, you cannot afford to overpay for real estate investments if you expect to retire on the income. Sure, there is a lot to be said for leverage and appreciation, but at the end of the day the cash flow is what counts.

So how does an investor assure himself that s/he is making the right decision and assembling an income and expense statement that is accurate?

1. Examine many similar properties at the same time.
It is helpful to examine similar pro formas at the same time. You will see what one owner or broker may include, and what another may leave out. Look at the market to see how long it is taking to find a new tenant. Talk to other real estate brokers, lenders and property managers in the market to establish a baseline.

2. Review operating numbers for the past three years.
Most financial analysis reports will exclude capital expenses. Bear in mind that you must reserve for capital expenses. The roof will leak, the HVAC will fail, and the main water line will break. I guarantee things will happen that you do not expect. Prepare financially for potential problems. Remember that real estate is an asset that wears out: doors need to be painted, carpets replaced, new faucets installed, etc. By reviewing three years of income and expenses, you will have a much better idea of vacancy rates as well as real expenses.

3. Obtain comparable rent income numbers.
Drive around the neighborhoods where your potential property is located. Call the brokers and the managers to find out what the rents are. Are there any concessions being given to rental units or lease space? Use this information to verify the figures you received for the property you wish to buy.

4. Examine the vacancy rate in the market place.
Each market and specific type of real estate investment has a vacancy rate. Some locations are better than others, and will perpetually have a higher occupancy rate. Look for concessions that have been offered. How will they affect your cash flow when you own the property? Why is your property full? Did the seller hastily rent to tenants from emergency aid shelters (yes, this has happened in weak markets). Banks will not loan on buildings with more than a 5% vacancy rate. They will, however, offer construction loans if you are renovating the building. This may give you some time to find tenants to fill a building, otherwise you will be forced to guarantee the rents, which means your hard-earned cash will not be at work making more money for you.

5. Talk to an appraiser regarding common incomes and expenses in the marketplace.
This seems like common sense, but no one seems to do it. The agent representing you is motivated to close a transaction. They may not be experienced, or may not provide all of the information you need. You need accurate information to make an informed decision.

6. Review the BOMA and IREM expense analysis books for the marketplace.
These books are updated every year and can give you an in depth look at how properties are operating.

7. Ask for schedule "E" tax return information for the property.
Many sellers will refuse to supply the schedule, but in my mind, the proof is in the pudding.
In my conservative opinion, cash flow is what the investor seeks. If your property has an 8% -10% positive cash flow after all of the adjustments discussed above, it should make sense. Many buyers also use CAP rates as an indicator of value; I find it to be a lagging indicator if you compare your property to others in the marketplace. Just because other investors are buying a 4% CAP property, does not mean you should. Maybe the market is overheated, perhaps there is more demand than supply, maybe you should look in a market with 8% - 11% CAP rates, or perhaps low interest rates give you the opportunity to buy something with a low CAP rate and still make money.

You should look at comparison indicators as you pursue your investment strategy:
CAP rate, cash-on-cash return, debt coverage ratios, price per unit (or price per square foot for comparable properties in the same marketplace), percentage of expenses (are they inline or understated). Don't forget to look at the financing and due diligence costs as part of your transaction.

All this analysis may mean that you will make lower offers than another investor. It may mean that you will not be willing to pay as much as a seller wants.
On the other hand, do you want to buy a property that will not appraise, or worse yet, not have a positive cash flow? I do not think so.