Real Estate Valuation & Cash Flow Analysis

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San Francisco Skyline (Complete photo by Loic Le Meur)
San Francisco, CA — home of some of the most expensive real estate in the world! (Photo credits are located at the bottom of this page.)

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Introduction: Residential and Commercial Real Estate Investing 101 (Part 3)

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Hello again, and welcome to the third installment of Residential and Commercial Real Estate Investing 101.  Over the past two articles, we’ve touched upon many of the basics — e.g., the pros and cons of investing in real estate, indirect and direct investment options, the importance of evaluating the appreciation potential and projected cash flow of a property — so that by now you should have a pretty good idea of what real estate investing is all about, as well as the type of property (or properties) that you would like to purchase.  However, if you are joining the class for the first time, then rest assured you have nothing to worry about!  The articles in this tutorial may be read in any order (or even independently of one another), and I have provided links below for the first and second installments:

Now then — let’s get to it!

Before you begin pouring over listings in search of your first investment property, let’s discuss a few of the more analytical principles of real estate investing — that I have up until now only described in the most general way — to ensure that you have all the tools you need to select properties intelligently.  Specifically, you need to know exactly how to analyze local economic indicators that will help you determine whether or not a prospective property is in an appreciable area (or an area that is poised to appreciate).  Also, I will spend some time explaining why it is so important to have access to reputable agents, inspectors and appraisers when buying real estate.  Finally, we’ll go over a systematic procedure for estimating the expenditures you will face as owner of a specific property, and whether or not the income you hope to make (from the property) will cover these.  This last step in particular is an especially important factor, because in the early years of ownership mortgage interest and fees associated with owning real estate are highest.

I’ll elaborate on all of these topics and more in the following paragraphs:

Evaluating Region Specific Economies and Local Housing Markets

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The skyline of San Antonio, TX — the seventh most populous city in the U.S. — as seen from the Tower of the Americas (Photo by Ken Kinder)
The skyline of San Antonio, TX — the seventh most populous city in the U.S. — as seen from the Tower of the Americas

The marvels of modern technology are truly amazing.  With an internet connection and a few clicks of the mouse, investors can purchase property halfway around the world if they so choose!  There is something to be said for buying real estate locally, though, as it is much easier to research and manage properties in an area with which you are already familiar.

At any rate, when considering a piece of investment real estate, it is important to assess the economic health of the surrounding area, to gain perspective about the kind of appreciation you can expect over the years.  Communities that are dependent on a small number of companies (in very few sectors of industry) to provide jobs can get into a heap of trouble if those companies go under — or simply pack up and leave.  Therefore, look for property in an area where a variety of employers have set up shop.

Moreover, take note of whether the employment sectors in an area are growing or shrinking.  For example, those communities that have been heavily dependent on manufacturing jobs have taken a beating over the years, as more and more companies move their operations overseas where labor is cheaper and regulations are scarce.  Retail jobs are also on the decline.  On the other hand, sectors like business services and IT, construction, as well as hospitality have all shown signs of growth in the U.S.1

You will also want to look at how the unemployment rate in an area has changed over the years.  Look into whether more jobs are being created or taken away.  You can find all of this information on the U.S. Department of Labor / Bureau of Labor Statistics website.

Once you have identified an economically viable area, it will be necessary to take the temperature of the local housing market.  Always remember that the ratio of supply versus demand (and vice versa) governs the pricing in any market.  In real estate, this translates to the supply of developable land in any given area.

As touched on in Part 1, this is one of the main reasons why properties located within thriving metropolises like New York City and San Francisco are so high.However, it’s not quite so simple as that, because if the supply of developable land in an area is too scarce — resulting in stratospheric real estate prices — then people could simply opt to move elsewhere, rather than deal with the inflated costs associated with operating in an overly-expensive area. (At least one expert believes that San Francisco will suffer from this phenomenon in the long run, unless changes are made to existing zoning laws.)3 The opposite is also true, as an excess of developable land translates into falling real estate prices.

So, is this a prime example of a catch-22?  If land is too scarce, then the economy may suffer from fleeing people and businesses; if land is too plentiful, real estate prices will sink like a rock!  Surely this is a case of “damned if you do, damned if you don’t,” right?

Not necessarily — as with all things, the market seeks balance.  Let this simple truth inform your investment decisions, and try to choose properties located in an area where the economy is expanding at a slow to moderate pace (i.e., not too fast and not too slow), where the demand for housing is increasing abreast of that expansion.

Other examples of solid, measurable data that you can examine to help you diagnose the health of local real estate markets include:

Building Permits for Residential and Commercial Development Projects – What you are looking for here is an overall trend in the number of permits granted (in an area) over time.  Go back several years and see if this number appears to be growing.  If it is, that could be an indication of supply overtaking demand in the real estate market, which will hinder appreciation rates.

Vacancy Rates for Rental Properties – Similarly, a high vacancy rate for rental properties in an area betrays an excess of supply relative to demand.  Low rental rates will inevitably follow, as desperate landlords trip over themselves to attract tenants.  Conversely, if vacancy rates are low, you may take this as a sign that the demand for real estate in an area is greater than the available supply, which increases rental rates and appreciation potential for investment property.

Rental Rates – Again, here you are not only looking at the current rent pricing in an area, but the trend of rental rates over the years.  This information correlates directly with the local demand for housing.  For example, rent will increase as the economy continues to expand (at a slow to moderate pace, as discussed earlier) if the supply of housing does not overtake that demand.  It follows that appreciation potential for investment properties will also increase in that desirable scenario. (An exception to this principle would be where a property is subject to rent control.  If so, there is a very real possibility that your expenses will increase faster than your ability to raise the rent!)

Ratio of For Sale Property Listings to the Number of Sales – If you have been paying attention up ‘til now, then I’m willing to bet you have already deduced what this ratio will tell you about a local real estate market; because, when all the fancy rhetoric, complex charts, formulas, equations and market prognostications have been distilled, we will always be faced by that stark, irrefutable and all-governing economic reality: the law of supply and demand.  Just as an excess of residential construction can indicate that supply is outpacing demand, so too does a high number of market listings show that there are more people selling their holdings than there are buying (which drives prices down).

This can happen when property values in an area reach high levels, prompting short-sighted real estate investors to cash in their chips while the getting is good.  All too often, a cascading effect of skittish investors jumping ship (i.e., putting their real estate up for sale) one after the other — with herd-like enthusiasm — ensues, driving formerly attractive prices further down with each new listing.  Moreover, the resultant drop in real estate values that has been precipitated by this over-stacked supply encourages more people to buy rather than rent.  This, in turn, leads to bargain basement rental rates — that could stay low for at least as long as it takes for the flooded pool of available real estate to dry out (i.e., for the market to correct itself) — as landlords attempt to make the cost of rent seem more appealing.

… Quite a debacle, right?

And yet, this example serves to remind us that it is generally not a good idea to follow suit, and react to short-term market fluctuations like droves of investors do.  When you follow the crowd at chow-time, chances are that the best vittles will already be taken before you get to the mess hall.  One trick is to beat everyone else there, but this can prove difficult.  It is much easier to simply wait for everyone to leave, then grab a clean plate and sit down, so that you will be first in line for the next meal!

For example, if you allowed the above hypothetical scenario to play out a little more, property values would start to increase again after the number of listings had been curtailed by eager buyers — or to put it another way, once the supply of real estate had shrunk.  Rental rates, too, would increase as more people tend to rent rather than buy at higher prices.  As mentioned previously, a desirable and efficient real estate market (from an investor’s point-of-view) will show a decreasing, lower number of property listings, indicating that supply is not overtaking demand.

Earl’s Insights: The Rise and Fall of Steel City

View of downtown Pittsburgh, PA's Central Business District (Photo by 'CBC')
View of downtown Pittsburgh, PA’s Central Business District (also known as the “Golden Triangle”)

I grew up in Western PA, near Pittsburgh — a place built by the blood, sweat, and tears of blue collar steel workers.  But when the tides began to change and the steel industry dried up, Pittsburgh and the surrounding communities suffered greatly.  Local economies relied heavily on jobs from that sector, so it is understandable that this sudden vacuum would throw the area into (economic) chaos.4 It has taken many years for Western PA to recover from the exodus of the steel industry. (Unfortunately, Pittsburgh seems to be repeating past mistakes with the current, overwhelming reliance on the Healthcare sector to provide regional employment!)

Real Estate Valuation

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Now that you know what criteria to look at when scouting for areas with a strong local economy and a healthy real estate market, let’s talk about how to assess the value of a specific property that catches your eye.  Always keep in mind that the “list price” is not necessarily reflective of fair market value, and so you must analyze every prospective piece of real estate that you seriously consider.  Otherwise, you run the risk of being taken for a rube (i.e., overpaying) by unscrupulous sellers and agents.

Townhouses in the wealthy Upper East Side of the borough of Manhattan, in NYC (Photo by Roy Googin)
Townhouses in the wealthy Upper East Side of the borough of Manhattan, in NYC

Once you have identified a solid-looking investment property that appeals to you, compare the list price to similar properties in the area.  If you are looking at a 3-bedroom single-family home with two bathrooms, find out what other nearby 3-bedroom/2-bath single-family homes have sold for recently.  Try to tailor your search so that you are comparing properties that share more than the obvious similarities (e.g., building age/condition, room/unit counts, lot/yard size) but also additional amenities and features (e.g., working fireplaces, in-ground pools, separate multi-vehicle garages, stained glass windows) in order to get a more accurate picture.  Just realize that some features aren’t going to match up, and you will need to assign a value to any differences before you can adjust the selling price accordingly for an apples-to-apples comparison.

Search Homes for Sale in your area

Also, don’t forget to take any price differentials resulting from fluctuations in the overall real estate market into account.  For example, say that you have been able to find a similar 3-bedroom single-family home to compare with the one mentioned above, which sold a year ago for $100,000.  However, in the twelve months since, housing market prices have increased by six percent overall.  Therefore, you would multiply the sale price of that property by six percent ($100,000 x .06 = $6,000, and $100,000 + $6,000 = $106,000), before comparing it with the price of the house you are interested in.

Real estate agents can provide you with a lot of the information you need, including a list of selling prices for properties that are comparable to the one(s) you are looking at.  But keep in mind that it is always in an agent’s best interest to recommend a higher price, and take their advice with a grain of salt.  A common tactic is to tell a client that the higher the offering price, the more likely a deal is to succeed.

Alternatively, you may choose to enlist the services of an appraiser to do the work for you.  This could set you back as little as a few hundred bucks for smaller properties like the single-family home mentioned above, or as much as a thousand or more for larger properties (e.g., multi-unit apartment and commercial buildings).  Seek out full-time professionals who have experience with the kind of real estate you are interested in.  Also, have appraisers provide you with a list of ten properties they have valued recently (i.e., within several months).  Just remember: an appraiser’s fee is non-refundable should you decide not to buy!  But whether you opt to hire an appraiser or not, never purchase a piece of real estate without having an independent inspector go over the property for any problems.

Cash Flow Analysis

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After you have identified an economically viable area for real estate investment and performed a thorough valuation on a potential property, there is one more important series of calculations to make before you decide whether or not to buy: cash flow analysis.  As discussed in Part 1, cash flow is the monthly expense associated with owning a property (e.g., mortgage payments, insurance, maintenance costs) subtracted from the amount of monthly rental income you expect to earn.  If you determine that a piece of real estate is going to cost you more per month than you will be able to earn from it, then buying the property simply cannot be justified — from a financial perspective, at least.

Some folks make the mistake of performing cash flow analysis in a lackadaisical manner, hurriedly calculating broad estimates without considering every expense that they will be responsible for.  Similarly, many people rely on financial statements compiled by sellers and their real estate agents in lieu of assessing cash flow, believing that these packets contain objective expense-to-profit ratios for properties (which they don’t).  In fact, more than a few fledgling real estate investors have ended up in personal bankruptcy after buying properties without performing thorough cash flow analyses.

A more useful document to ask for when you are considering a piece of real estate is the Schedule E (Supplemental Income and Losses) form of the owner’s most recent tax return.  Unlike the Realtor financial statements discussed above, Schedule E forms are meant for the Internal Revenue Service instead of prospective buyers.  The “supplemental income” portion of the form is where rent collected during the year is reported, and the “losses” section is where property owners list the various outgoing expenses (e.g., repairs and maintenance) associated with the property that they have had to deal with.

As you might have guessed, a Schedule E form will give you much more honest information about what is really going on with a property than a Realtor’s sales-pitch oriented financial statement.  To draw a comparison: if the financial statement is a property’s e-Harmony profile, then the Schedule E is its rap sheet.  If a Realtor or owner seems evasive about handing over this form proceed with caution, as it may be an indication that there is something seriously wrong with the property in question.

Bearing the above topics in mind, you should now be ready to approach cash flow analysis with a healthy amount of skepticism.  That said, it is perfectly natural to view a potential investment property through the lens of optimism — just don’t let visions of the obscene amount of money you are going to make as a real estate tycoon overtake reality!  Frankly assess the repair, maintenance and miscellaneous operating expenses that you will be responsible for as owner of a specific property, and weigh that against your expected revenue stream.

The following step-by-step procedure will walk you through a typical monthly cash flow analysis, in three parts:

1. Total income (monthly) — First, you must tally up every type of income that you expect to earn from a property per month.  For single-family homes, this will just be the rent you collect from tenants in most cases.  However, multi-tenant properties such as apartment and office buildings may include other sources of revenue, like money from vending machines and coin-operated laundry rooms, parking, internet, as well as miscellaneous income from storage or concierge services.

2. Total expenditures (monthly) — Next, begin making a list of every monthly expense associated with the property under consideration — of which you would ultimately inherit the burden should you decide to buy — and remember that this is one time where you should sweat the small stuff!  Be thorough, and give ample attention to expenses both large and small.  Think about lateral costs like water and utilities, waste disposal, cleaning services, periodic maintenance such as pest extermination and miscellaneous upkeep, property management service and legal fees if you have them, in addition to “the big three” — i.e., mortgage costs, property taxes, and insurance fees. (Note: Water and utility expenses vary from season to season. Therefore, ask for a year’s worth of billing statements for the property in question and add them all up. Then, divide the total amount by twelve to arrive at the average monthly cost that you will incorporate into your cash flow analysis.)

3. Take the monthly expenditures total from Step 2 and subtract it from the monthly income total from Step 1, to obtain the positive or negative amount of cash flow that you may expect to earn/lose from the investment property in question (or: TMI – TME = CF+/-).

Keep in mind that the cash flow analysis for real estate in a depressed area may seem more attractive at first glance, due to the reduced cost-of-living in such places.  However, the trade-off comes with abysmal appreciation on your property over time.  In order to give yourself the best chance at success, it is necessary to take all three principles of intelligent real estate investing into account — i.e., economics, property valuation and cash flow analysis — before deciding whether or not to make a purchase.  If you can manage to do that while remaining patient and perseverant, then you not only have an excellent chance of finding success as a real estate investor, but of meeting your long-term financial goals as well.

Earl’s Insights: Realtor Financial Statements & Schedule E Forms Defined 

Realtor Financial Statements – Informational packets for prospective investors that are compiled by real estate agents and sellers, designed to gloss over flaws and other concerns in order to paint properties in the most attractive light. For example, the cash flow analysis included in such a financial statement might only contain estimates for a best-case-scenario.

Ask for a copy of the 1040 Schedule E (Supplemental Income and Losses) section of a seller's most recent tax return! (Photo by Philip Taylor)
Ask for a copy of the 1040 Schedule E (Supplemental Income and Losses) section of a seller’s most recent tax return!

Schedule E Forms — Also known as “Supplemental Income and Losses” forms, these IRS documents are where owners report rental income earned and outgoing expenses paid for investments such as real estate on their personal tax returns. These forms are much more informative than Realtor financial statements, and sellers should have no problem providing potential buyers with a copy of their most recent Schedule Es when asked (non-relevant information pertaining to other investments may be easily blacked out, so privacy is not an issue).

<–[PREVIOUS] Part 2 of Residential and Commercial Real Estate Investing 101: ‘How to Invest in Real Estate Directly’

[NEXT]–> Part 4 of Residential and Commercial Real Estate Investing 101: ‘Negotiating Deals and Avoiding Scams in Real Estate Investing’

Resources

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  1.   Sharf, Samantha. Jobs report: U.S. economy added 113,000 jobs in January, unemployment down to 6.6% [Internet]. New York, NY: Forbes; 2014 Feb 7 [cited 2014 Feb 22]. Available from: http://www.forbes.com/sites/samanthasharf/2014/02/07/jobs-report-u-s-economy-added-113000-jobs-in-january-unemployment-down-to-6-6/
  2. Barro, J. Dear New Yorkers: here’s why your rent is so ridiculously high [Internet]. New York, NY: Forbes; 2013 Jul 9 [cited 2014 Feb 24]. Available from: http://www.businessinsider.com/the-8-reasons-why-new-york-rents-are-so-ridiculously-high-2013-7
  3. Briem, Christopher. For Pittsburgh a future not reliant on steel was unthinkable … and unavoidable. Pittsburgh, PA: Pittsburgh Post-Gazette; 2012 Dec 23 [cited 2014 Feb 22]. Available from: http://www.post-gazette.com/business/businessnews/2012/12/23/For-Pittsburgh-a-future-not-reliant-on-steel-was-unthinkable-and-unavoidable/stories/201212230223
  4. Metcalf, G. The San Francisco exodus [Internet]. San Francisco, CA: The Atlantic Cities; 2013 Oct 14 [cited 2014 Feb 24]. Available from: http://www.theatlanticcities.com/housing/2013/10/san-francisco-exodus/7205/
Photo Credits

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  1.  “San Francisco Skyline.” Source: Loic Le Meur, CC-BY 2.0, via Flickr. 2012 Oct 25 [cited 2014 Feb 22]. Available from: http://www.flickr.com/photos/loiclemeur/8479307253/
  2. “Downtown San Antonio, TX.” Source: Ken Kinder, CC-BY-SA 3.0, via Wikimedia Commons. 2005 May 14 [cited 2014 Feb 22]. Available from: http://commons.wikimedia.org/wiki/File:Downtown-san-antonio.jpeg
  3. “Downtown Pittsburgh.” Source: CBC at de.wikipedia, CC-BY-SA 3.0, via Wikipedia Commons. 2007 May 18 [cited 2014 Feb 22]. Available from: http://commons.wikimedia.org/wiki/File:Downtown_Pittsburgh_1.jpg
  4. “Sutton Place Townhouses.” Source: Roy Googin, CC-BY-SA 3.0, via Wikimedia Commons. 2009 Jun 29 [cited 2014 Feb 22]. Available from: http://commons.wikimedia.org/wiki/File:Sutton_Place_Townhouses.jpg
  5. “Filing Taxes – 1040 Form.” Source: Philip Taylor, CC-BY 2.0, via Flickr. 2012 May 1 [cited 2014 Feb 22]. Available from: http://www.flickr.com/photos/9731367@N02/6984657584/
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