Learning to screen and analyze investment properties is truly an art.
But, fortunately for physicians, there is also some science behind it. I guess as a plastic surgeon in a field where art often meets and melds with science, I am uniquely positioned to comment on this strange process that is essential to successful real estate investing.
The problem with the science of real estate screening and analysis is that there are so many metrics out there. And there are an equal number of proponents pushing each different metric. It can be very overwhelming.
My goal with this guide is to lay out, in simple terms, my methods for screening and analyzing real estate investment properties.
Disclaimer: I am not an expert. But I do know my stuff. I have bought one investment property with my wife. But we did a good job and plan to employ these methods with many more properties.
Let’s get a few things out of the way first
First, if you are brand new to the concept of real estate investing, please take a moment to first read my Physician’s Guide to Real Estate Investing. That post will give you the foundational knowledge to follow along with the ideas presented in this post.
Second, I am a strong believer and proponent of Buy, Fix, Rent, and Hold real estate investing. I believe that this is the best way to build wealth with the least amount of risk. Notice I didn’t say no risk, because there always is some. But this is the best way to maximize returns and minimize risk with investing in my opinion.
Third, take what you like and ditch what you hate. Ultimately, this is what I did. I read a ton of books and blogs and talked to a ton of investors. Some of what I read and heard, I liked and some, I didn’t. Thats how I developed my personal strategy. You should do the same.
Why do I think my way to analyze investment properties is the best?
Keep. It. Simple. Stupid.
The K.I.S.S. principle. In life, in surgery, in real estate investing, there are people who make things complicated and people who make things simple. I always sought plastic surgery mentors who broke things down to simple principles that could be successfully applied to new situations.
This is what I do with my real estate screening, analysis, and ultimately investing strategies.
Here we go…
The right way to screen rental properties
Screening properties means that you are looking through Redfin or your investor agent brings you a property and you need to decide if you will do more research or take a hard pass.
You should screen properties using the 1% rule.
Basically, take the monthly rent that the property will reasonably bring in and divide it by the purchase price. For example, you find a $150,000 duplex property that should be able to get $750 in monthly rent from each unit. That equals 1% ($1500/$150,000) using the 1% rule.
This means that I would take a closer look at this property. If the monthly rent for both units was only $900, that would only be 0.6%. I would take a pass.
It’s that easy. Don’t waste your time on properties that are not likely to pan out. You’ll get burned out and frustrated. Focus on the properties that are likely to fit your criteria.
Of course, there are exceptions to every rule. If a property hits 0.9%, I’d probably still check it out. If it hits 0.7% but it seems like the rents are way under market or I can do something with rehab to increase rents, maybe I still take a look.
On the converse, if I find a property at 1.5% but I know it’s a bad area where rents are hard to collect, I may still pass. But in general, I follow the 1% rule in 95% of cases.
See that wasn’t too hard.
Rents will not always be on the listing for a property. Even if they are, they may be artificially inflated by unscrupulous agents. Here’s how to get around this in the screening phase.
Download Rentometer on your phone. This app estimates rents for apartments based on address and number of bedrooms. It’s not perfect but will give you a good general sense to use for the 1% rule.
The right way to analyze investment properties
Once you screen a property and it meets the 1% rule, the real work begins.
You now have to figure out if this property is going to meet your criteria, be a valuable addition to your portfolio, and help you reach your financial goals.
The way that I figure this out is using the cash-on-cash return metric.
Cash-on-cash return (CoC) is the percentage of annual cash flow that a property puts in your pocket divided by the amount that you paid out-of-pocket for that property.
I pursue properties that reach an expected CoC return of 10% or greater. If it meets that mark, I am going to make an offer. If not, I’ll pass.
An example of how to analyze an investment property:
You buy that $150,000 property using a mortgage with 25% down. You also pay $5000 in closing costs and put another $5000 into renovating the property before renting it out.
So, you put $47,500 out of your pocket into the property ($37,500 for down payment + $5000 closing costs + $5000 renovation = $47,500).
Now, let’s say that after paying the principal and interest on the mortgage, maintenance, taxes, insurance, and all other expenses, you make $400/month from the property. That equals $4800 annually.
Therefore, your CoC is 10.1% ($4800/$47,500).
Boom…you should lock up this property!
How to figure out the cash-on-cash return of a property?
Obviously, the above example is a bit artificially straight forward. A lot of numbers go into figuring out the CoC return of a property.
The CoC Denominator
The easy part is figuring out how much money you are paying out of pocket for the property. That is a simple equation:
Money out of pocket = Down payment + Closing costs + Repairs/Renovation
The down payment and closing costs are easy to estimate by asking your lender. The repairs/renovations estimates can be a bit more tricky. I recommend walking around the property with your contractor to get a sense. You can even bring them to your showing or open house. You can also ask your real estate investor agent if they have a lot of experience but tread carefully (they want to sell to you and some agents may be inclined to underestimate).
Whatever that value is will be your denominator in the CoC equation.
The numerator is a bit more tricky
The first step to figuring out your numerator (AKA the annual money that the property puts in your pocket), is to get an accurate estimate of how much rent you can get.
I already mentioned Rentometer as a good option to get a general sense. But there are 3 other ways that you should confirm that your rent estimate is accurate:
- Compare to similar listings on rental websites like Zillow or Apartments.com
- Ask your investor real estate agent (make sure that they are actually an investor real estate agent first)
- Ask your property manager (or if you are self-managing, just call property management company and ask, they are happy to help. We did this)
Once you have monthly rent, you need to figure out all of the other estimated monthly expenses.
- Mortgage principal and interest
- Estimated vacancy and turnover (usually use 5-10%)
- Property management fee (if using a property manager – most property managers charge 10% of monthly rent)
- Unit turnover fees (if using a property manager for this – most PMs will charge one month’s rent for this service)
- Estimated maintenance costs (usually use 5-10%)
How do you find estimates for all of these variables?
It can seem overwhelming to figure out all of the estimated expenses, but it’s actually not too hard.
For your mortgage principal and interest, just ask your lender. For utilities, just call the utility companies. They will give you averages for that property over the past few months. For insurance, ask your insurance agent. For property management and turnover fees, ask your property manager or put $0 if you plan to self manage. And your estimate maintenance and vacancy can usually be safely assumed at 5-10%.
Err on the side of OVERestimating your expenses always. You want to bake some room for error into your calculation.
Putting it all together
Once you have the monthly expenses, simply add them up and subtract from your monthly estimated rent amount. Next, multiply by 12 to get the annual net income. The resulting number will be the numerator for your CoC equation.
Now, all you have to do is divide this number by your denominator, the out-of-pocket amount, and you have your cash-on-cash return.
You can figure this calculation out via pen and paper, online calculators, or using a simple spreadsheet, which is what I use.
If this CoC is 10% or greater, this should be a property you seriously consider placing an offer on.
If it doesn’t meet your CoC criteria, you can always play with the variables. Maybe if you bill back utilities, the numbers work out. Maybe if the seller decreases the purchase price by $10,000, the CoC goes to 11%.
Negotiate based on your criteria. That’s the beautiful thing about investment real estate. You fall in love with the numbers. If a property doesn’t meet your numbers, don’t get emotionally attached, just move on to the next one that does.
The way you analyze investment properties will set you up for success.
Bonus: The right way to valuate rental properties
I throw in this last section as a bonus and also because I know someone will mention how they like to use Net Operating Income (NOI) rather than CoC to analyze investment properties.
Simply, NOI = annual property income – all expenses except mortgage principle and interest
People will then calculate a percentage based on NOI/purchase price of the property. Usually, people will shoot for a percentage of 8% or greater.
So, this NOI ratio is basically your CoC if you buy a property with all cash AKA no mortgage AKA no financing.
I don’t use this metric for to analyze investment properties in determining if I will buy them because it does not take leverage into consideration.
Leverage is the idea that when you buy a property with a mortgage, you don’t pay for the whole property but you get to enjoy the benefits of owning the whole property. You don’t want to become over leveraged (that’s a whole other post). But, using leverage to accelerate your portfolio and net worth is certainly a worthwhile strategy when used responsibly.
Therefore, in my mind, CoC paints a much more realistic picture of what I am doing compared to NOI.
But NOI does still have a role in analyzing investment properties
Remember, this NOI percentage (let’s call it X%) is based on the equation: Annual NOI/purchase price.
Let’s do some elementary school algebra to rearrange the equation:
Purchase price = Annual NOI/X%
Now, I can use these variables to find out how much I could reasonably expect to sell an investment property that I own based on these variables. The NOI is easy to calculate based on rent and expenses. The X% value is based on local market data but 8% is reasonable in general.
So, let’s say I bought a property for $150,000. My NOI (Income – Expenses not including financing) is $1000/month or $12,000 annually. My NOI % ($12,000/$150,000) is therefore 8% when I buy it.
Now, let’s say I fix it up and increase rents and get the tenants to pay utilities and my NOI goes up to $1500/month or $18,000 annually.
Let’s plus these numbers into our equation above:
Purchase price = NOI/0.8% (based on local market data) = $18,000/0.08 = $225,000!
Now I know that I should be able to sell my investment property for a $75,000 profit (before transaction fees and taxes, etc.).
In vaulting investment properties, NOI is a helpful metric. But, to analyze investment properties, CoC is much better than NOI in my opinion.
Ok, let’s summarize
I know that there was a lot of information there. But let’s break it down again using K.I.S.S. principles.
- To screen investment properties, use the 1% rule (Monthly rent/Purchase price >/= 1%)
- If it meets criteria, move forward to more analysis
- If it doesn’t meet criteria, move on to another property
- To analyze investment properties, use cash-on-cash return (Annual Net Income/Money Out of Your Pocket >/= 10%)
- If it meets criteria, lock up the property by placing an offer based on your criteria
- If it doesn’t meet criteria, move on to another property
- To valuate investment properties, use NOI (Annual Income not including financing)
- Estimated Sale Price = NOI/X% (based on local market data, usually 8%)
Real estate investing is a real wealth accelerant. But many people, physicians in particular, hold a lot of limiting beliefs that stop them from pursuing these opportunities.
Take action today to get on the path to financial well-being!
- Find out how to automate your real estate investments
- Learn how real estate can lead you to financial freedom
- Establish your “why“
- Create the habits for financial success
What do you think? How do you assess potential investment properties? What has stopped you from getting started in real estate investing? Did I miss anything? Let me know in the comments below!