How to Analyze a Real Estate Deal

A rental property can look like a great deal on a listing and a poor one once every cost is counted. Analyzing a deal means turning the listing into a few numbers you can compare, and being honest about the expenses that are easy to leave out.

Start with the rent you will actually collect

A listing quotes the full rent. Real properties sit empty between tenants, so subtract an allowance for vacancy before doing anything else. What remains is the income you can plan on.

Subtract the operating expenses

Operating expenses are the costs of running the property, whether or not it has a mortgage:

• Property taxes and insurance.
• Maintenance and repairs, from a dripping faucet to a new water heater.
• Property management, even if you plan to manage it yourself: your time has value, and you may not always want to.
• Utilities, fees and services the owner pays, such as water, trash collection or association fees.

Rent after vacancy, minus operating expenses, is the net operating income (NOI). It describes the property itself, before any loan.

Big replacements such as a roof or a heating system are not operating expenses, so they sit below NOI. They come rarely but expensively, and the money you set aside for them each month (often called capital expenditure reserves) comes out of your cash flow. The example below leaves them out to keep the math simple, so in real life its cash flow would be lower still.

Three numbers for comparing deals

• Cap rate: yearly NOI divided by the total cost of the property. It compares buildings regardless of how each one is financed.
• Cash flow: NOI minus the loan payment and any reserves you set aside. It is what is actually left each month, and it should be positive with room to spare.
• Cash-on-cash return: yearly cash flow divided by the cash you put in, including the down payment and closing costs. It shows what your own money is earning.

The expenses beginners forget

Leave vacancy and maintenance out of the example and cash flow jumps from $150 to $450 a month, which looks three times better on paper. Nothing about the building changed, only the honesty of the math. If a deal only works when the property is always full and nothing ever breaks, it does not work.

Stress-test before you commit

• Run it at a higher interest rate than you were quoted. In the example, a loan payment of $1,100 instead of $1,000 cuts cash flow to $50 a month.
• Run it with a longer vacancy, such as one or two empty months in a year.
• Keep reserves in cash for repairs and empty months. Reserves are part of the cost of owning, not an optional extra.