How To Analyze a Potential Real Estate Investment

Before you make your next investment –that is, before you decide whether to use that Rs. 500 bill in your wallet to buy a new jean or to order a pizza – it would be good a good idea to ask yourself if you’re at all serious about wanting to make money utilizing a potential Real Estate Investment.

In real estate, there is a right way and a wrong way. If you want to succeed, if you want to make money from it, then you need to learn to do things the right way. With a bit of knowledge and practice, you’ll be able to read a property’s critical signs and judge its health as an investment.

The four basic returns of real estate investment

Without knowing key formulas of real estate investment, you’re really just guessing when you try to figure out whether a given property is a good investment. You may think you have a profitable property because it generates excellent rental income, but when you examine it more carefully using some of these rules, you realize that what you have is a loser.

Cash flow
Appreciation
Loan Amortization
Tax shelter

These four returns comprise the complete pool of potential benefits. The real estate investment decisions you make will depend on your personal goals and on the strength of these various returns. If you understand where they come from and how to calculate them, then you’re well on your way to success. Let’s dwell a little deeper into these four returns.

Cash flow

If you look at a particular period of time (12 months), you’ll want to know if more cash comes in then goes out. If at the end of that time you can say that you took in more money than you spent, then you had a “positive cash flow” for the year. If a real estate investment has a positive cash flow (i.e., if there is money leftover after all the bills are paid), that’s money you can take off the table.

On the other hand, if you have spent more than you took in, you had a “negative cash flow.” A property with a negative cash flow doesn’t provide you with any spendable cash. On the contrary, it requires that you put more of your personal funds into the property to make up the difference.

Appreciation

Here the appreciation is defined as the growth in value of a property over time. The questions that should come to mind immediately in regard to real estate appreciation are, “How much growth?” and “How much time?” To answer these questions, you need to consider a more fundamental issue, “What causes a property to appreciate in value?”

The answer is revenue—particularly net revenue (after operating expenses)—drives the value of income property. We knew that real estate investors really buy the property’s income stream. If you have more income streams to sell, you can expect to get more for it. Hence, the faster and the greater your revenue increases, the more likely it is that the value of the property will increase.

Loan Amortization

It’s really nice when someone else pays your bills. In effect, that’s what happens when you use a mortgage loan to help you purchase an income property. Consider a Rs. 10 crore office building. You could write a check for the full amount but, sadly, that would almost clean out your bank account. On the other hand, you could write a check for just Rs. 3 crore and get a loan for Rs.7 crore . That would leave you with enough money to buy two more similar buildings and still have change leftover.

You use a mortgage loan to purchase the property. Each month your tenants give you the cash needed to pay down that debt. They are your potential suitors for profitable real estate investments and this is also called amortization i.e the liquidation of this debt by the application of installment payments over time.

Tax shelter

The last of the four basic returns is tax shelter. A potential real estate investment can shelter some of its own income from taxation and occasionally shelter income received from other investment sources as well. How does it do that?

As owner of an investment property, you take in taxable rental income and pay out tax-deductible operating expenses like insurance and repairs leaving you with a “net operating income” (NOI) on which you would expect to pay taxes. However, to promote the general economic benefits that tend to flow from real estate development the tax code permits further deductions that are mortgage interest and depreciation deduction.