How To Analyze Real Estate - The Real Estate Stack
Today, let's take a look at a model that I refer to as the Real Estate Stack. This is the most basic of measurement models which allows an investor to take an investment and convert it to a mathematical model so that it can be compared with all other investment opportunities.
Too often, I see "wanna-be" investors wanting to go look at properties. Personally, I never like to go look at investment properties until I've already seen the numbers potential. If the numbers are not super attractive, then looking at the property is not only a waste of time, but it also brings in the opportunity for faulty decision making through emotional attachment. I would hate to "fall in love" with a property where the numbers cannot work out as well as another property.
So, on to the Real Estate Stack. This is the most basic of mathematical modeling which allows the investor to determine the Net Operating Income (NOI) of a property. All the key terms in the model are explained below:
Potential Gross Income (PGI)The Potential Gross Income of a property is simply the "best case scenario" of what it can generate in rent. If a property can rent for $900-$1,000 per month for rent, the the PGI would be $1,000 x 12 = $12,000 per year.
Vacancy and Collection Losses (V/C)Vacancy is the measurement of time, expressed in percentage of the year, that you would expect the property to not have a tenant. Every property will have periods of vacancy due to change-over in tenants plus market cycles that make it harder to find tenants.
Collection losses, much like vacancy in that no income is occurring, is when non-paying tenants are in the property and either need to be motivated or evicted. This too is expressed as a percentage figure annually.
The key to Vacancy and Collection Losses is that you can compare different types of properties in different market cycles. Perhaps a home in the higher price range will have longer occupying tenants, thus a lower vacancy, whereas a property in a student area can be expected to turn nearly every year, resulting in a higher vacancy. Using the correct figures for vacancy allows us to compare these two properties and determine which one is the better buy.
Effective Gross Income (EGI)Effective Gross Income is the amount of revenue we anticipate receiving annually while owning the property. This is not the "best case scenario," rather it is the "realistic case scenario."
Operating Expenses (OE)Operating Expenses are those things that the property owner must pay for while owning the property. Such expenses might include property taxes, hazard insurance, maintenance fees, management fees, homeowners association expenses, utilities, and reserves for replacements (roofs, HVAC systems, etc.).
Net Operating Income (NOI)The NOI is the amount of money that would go to any investor after receiving all income and paying all expenses, with the exception of payments on loans and income taxes. The NOI is important because it makes all real estate investments that are purchased for cash flow equivalent.
Annual Debt Service (ADS)This is the total of mortgage payments for the year. The annual debt service includes the principal and interest portion of the payment for all twelve months.
Cash Flow Before Taxes (CFBT)Cash Flow Before Taxes is the amount of money realized by the investor for the year, whether positive or negative, before income taxes are considered.
The Real Estate Stack
So there is the simple Real Estate Stack. Try it out. Use it with several properties to find out which ones will be better investments. You can check out yesterday's blog about Bull Run In Tallahassee Florida and see the Real Estate Stack in full operation. Let me know what you think!
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Joe Manausa is a real estate investor and the Broker and Co-Owner of Joe Manausa Real Estate. He can be reached via e-mail through the Tallahassee Real Estate Website or catch his latest writings on the Tallahassee Florida Real Estate Blog , or by calling (850) 386-2001.