How to Analyze Your Investment

Learning how to analyze your investment before you spend all of your money is critical in today's real estate market. Those of us who buy real estate primarily as a financial investment have an intriguing market to work with right now. Prices are low and many homes are particularly affordable thanks to high rates of foreclosure and other financial issues. But just because home prices are low, does not mean that investors are free to snap up houses at will with no forethought or strategy.

Choosing the right approach to real estate investment is just as important as finding the right house to buy. Going with the wrong approach or an inappropriate strategy given the market or the property being bought could cost you all kinds of money as an investor, eating into profits. There are multiple approaches used by real estate investors to evaluate value and potential returns. Here is a rundown of several such approaches.

Safe comparison approach: Compares the property to similar properties sold recently and calculates an average price per square foot to determine value of the home to be purchased.

Gross rent multiplier: A value estimate found by taking the sale price and dividing by potential monthly rent income. In other words, this gives a rough guess on how long a home would have to be rented out to recover the original purchase price. Many repeat investors use a form of this approach that emphasizes the potential rental income for the first year.

Direct capitalization (cap rate): Takes the net operating income and divides it by the sale price of the home. Expressed as a percentage of the list price or of the price that the buyer is willing to pay. It accounts for operating expenses associated with owning a property, gross rents, non rental income, vacancy and credit losses. Limitations of this method include lack of emphasis on long term outlook, owner financing costs, tax expenses, or property appreciation or depreciation.

Cash on cash: Takes a look at cash invested up front (not including any financed money) and compares it to first year cash flow before taxes. Divide cash flow before purchase by the amount cash invested for down payment on property. Accounts for the impact of owner financing as well as operating expenses, rents, non rental income, vacancy and credit losses. Does not account for owner property taxes or appreciation or depreciation in value of the property.

Demographics: Tries to project potential appreciation and the potential for obsolescence of a property by looking at building trends including demographic trends, which are profiles of possible current and future buyers. Projects appreciation as being driven by market demand and impacted by any obsolete features and other construction in the area. Asks the question: will this home still have what people will be looking for in the future?

Net present value of discounted cash flows (NPV): Calculates the dollar value of an initial investment by taking the sum of the present value of all future cash flows compared to the initial cash investment. High NPV indicates that the investment exceeds investor expectations for return.

There are other methods as well, each of which have advantages as well as limitations. The point is that there are many different ways to evaluate and analyze a potential real estate investment without actually putting down a single dollar. A wise investor will come up with a consistent and workable method to make these determinations in order to get the most value for every dollar invested in real estate transactions.

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