Real estate encompasses many property types, from multifamily residences to industrial spaces, hotels, and more. However, the fundamental principles of real estate analysis remain consistent. At its core, real estate analysis revolves around comparing a property’s valuation upon completion to the total project’s cost, with the difference representing your potential profit.
Here, we’ll delve into the essential steps of real estate analysis, covering cost evaluation, valuation determination, and sensitivity analysis. These steps are universally applicable, regardless of the specific property type under consideration.
Total Cost Analysis
Total cost analysis involves much more than just the purchase price of a property. It includes a comprehensive breakdown of all expenses associated with the investment, including:
Purchase price: This is the cost of the land or building itself and any associated closing costs.
Financing costs (if applicable): These costs come into play when you require financing, which can take various forms, such as construction financing, bridge financing, or permanent financing (not applicable in an all-cash transaction).
Hard costs: This category pertains to the actual construction expenses, whether it involves renovation or constructing a property from the ground up.
Soft costs: Soft costs encompass any design-related fees, such as architectural design costs, as well as permit-related expenses, such as building permits.
Holding costs: Before the property becomes operational, there are ongoing expenses to consider, even when the property is not generating revenue. These include property taxes, insurance, and other fees that you are responsible for during the holding period.
Precise financial oversight of these expenses is paramount to secure the feasibility of your investment. While seasoned investors can readily draw from historical data for cost estimations, those embarking on their first real estate venture may encounter a steeper learning curve. Nevertheless, the path to cost analysis is navigable, even for novices.
Consider the following steps for a comprehensive cost assessment.
Financing and soft costs
Obtaining an approximation of financing and soft costs is a relatively straightforward process. You can reach out to banks or debt funds for a preliminary financing cost evaluation and consult with an architect to gauge soft costs. The combined total of financing and soft costs commonly amount to approximately 15% to 20% of your hard costs.
Challenges in estimating hard costs
Estimating hard costs can be more intricate due to the inherent variability among general contractors (GCs). To address this challenge, it’s prudent to engage a GC who possesses a proven track record in projects that closely resemble your undertaking.
Projects of similar dimensions, quality standards, material choices (concrete/wood), and parking specifications can be compared using a cost per square foot ($/SF) metric to derive a rough estimate of your hard costs. In instances where architectural plans are available, submitting them to the GC allows for a precise and tailored cost evaluation.
By following these strategies, you can navigate the cost estimation process with greater confidence, whether you are an experienced investor drawing from a wealth of historical data or a first-time investor embarking on a new real estate endeavor.
Valuation of the Property
Property valuation is a pivotal juncture in the analysis process, and it exhibits a certain level of sensitivity to economic conditions. The valuation trajectory is notably affected by prevailing economic factors.
In recent times, it has encountered fluctuations, primarily due to escalating interest rates. Notably, the valuation of office properties has been significantly impacted by the lingering effects of the COVID-19 pandemic and the prevalence of remote work.
Understanding the valuation is paramount, as it serves as the bedrock upon which strategic decisions are built. Multiple methodologies can be applied, with the selection hinging on the property type and its intended purpose. These methodologies encompass the sales comparison approach (comparables), income approach (rental income and cap rate), and cost approach (replacement cost). The choice of approach is a tailored decision guided by the unique attributes of the property.
The cost approach, known for its conservatism, resembles the replacement cost in the current market. Nonetheless, a majority of real estate assessments pivot around the sales comparison and income approach, with the capitalization rate (cap rate) as a pivotal component of the latter.
Sophisticated models, often reserved for in-depth financial analysis, are employed to compute metrics like the internal rate of return (IRR) and net present value (NPV) for each deal. However, these intricate models are generally dispensable for preliminary feasibility studies or initial assessments conducted in a more informal manner.
To gauge the projected profit of your venture, simply subtract the total cost from the property valuation, but make sure to account for the broker or agent fees if applicable. Calculating your return on equity (ROE) necessitates dividing the estimated profit by the requisite equity investment. For those interested in approximating their average annualized return, dividing the ROE by the intended investment duration provides a clear picture of annual returns.
Sensitivity Analysis
Given that cost estimations and property valuations are seldom exact, sensitivity analysis is an indispensable tool in the realm of real estate investment. This method serves as a crucial means of evaluating how variations in key variables can influence your overall investment.
By adjusting variables such as cap rate, $/sf for sales, $/sf for costs, and net operating income (NOI), among others, you can gain a comprehensive grasp of the potential risks and rewards associated with your venture. Doing a sensitivity analysis empowers you to prepare for diverse scenarios, fortifying the resilience of your investment strategy.
To facilitate a sensitivity analysis, employing 5% intervals for both hard costs and soft costs is a prudent approach. This allows for the examination of five distinctive scenarios, including a range of -10 %, -5 %, 0%, 5%, and 10% deviations in both hard and soft costs.
Similarly, the analysis can be extended to exit prices, applying the same -10 %, -5 %, 0%, 5%, and 10% variances in the sale price. The convergence of these two variable axes forms a two-way variable data table, enabling a thorough exploration of multiple investment scenarios and their potential implications.
Here is a sample data table, with 20% as the IRR based on the original projection. As the hard cost and soft cost increase, the IRR goes down. When the exit price increases, the IRR increases.
Table 1. IRR sensitivity analysis based on costs and exit price
Final Thoughts
Real estate success hinges on understanding total costs and valuation and employing sensitivity analysis. Sensitivity analysis is an invaluable tool, allowing investors to gauge the impact of variable factors. By adjusting cap rates, sale prices, costs, and net operating income (NOI), it offers a holistic view of potential risks and rewards.
Sensitivity analysis equips you to navigate diverse market conditions and seize opportunities. Using 5% intervals for cost and exit price scenarios provides a robust framework for comprehensive exploration. This detailed examination prepares you for varying market conditions and bolsters your investment strategy.
Real estate analysis need not be overly complex. By concentrating on costs and valuation, you can simplify the process. While comprehensive analysis for cash flow and IRR can be useful, it’s not always necessary. What truly matters is understanding total costs and property valuations.
These are the cornerstones of sound real estate decision-making. With these two factors well understood, you can confidently navigate the real estate market, making informed investment choices and ensuring the financial viability of your endeavors.
So keep your focus on costs and valuations, and remember, sometimes simplicity is the key to success in the world of real estate.