It is cruital for a real estate investor to do an investment analysis before entering or beginning any new project. A successful rental home investor might have dozens of homes in their portfolio. Various factors lead to financial success with real estate investing. It is necessary to consider all of them. Buying right can result in double-digit returns and a solid flow of cash for years. Alternatively, if you don't do the necessary due diligence, you could find yourself the owner of a worthless investment property.
Net Operating Income
Any investment analysis begins with understanding net operating income (NOI). This value is the total income your property generates less any expenses it incurs. Such expenses include the costs you pay to maintain the property. Simply subtract total expenses from total income to arrive at your NOI. To determine your monthly NOI by dividing the resulting number by 12.
However, there is one catch. Your total expenses do not include loan costs.
Your cash flow is what's left when you make an additional adjustment for those loan costs, typically your mortgage. You're left with your cash flow when you subtract debt service from your NOI. This is your profit.
The more you borrow, the less your cash flow will be. Your NOI will equal your cash flow if you pay cash for the property.
Cash flow is admittedly a function of a great many inputs, and any of them can change and damage—or improve—a situation. Some inputs are influenced by the market and the economy. The demand for rental property can plummet overnight when a major local employer closes or moves. The Federal Reserve can increase the overnight interest rates driving up the cost of borrowing, and impact the overall real estate market. This change can make the cost of buying new properties more expense and reduce your cash flow.
You can't control things like this, but you can hopefully avoid these situations by doing your due diligence about the health and plans of local employers. Keep abreast of economic news and plan for changes in the interest rates. You're probably in good shape if your properties are profitable with a long lease that have been recently renewed.
The Depreciation Factor
Of course, the Internal Revenue Service (IRS) is going to want a percentage of all this rental income. However, investing in real estate offers quite a few tax breaks as well. One beak is the property depreciation deduction which is a valuable component in property analysis.
Depreciation even reduce taxable profits from other investments for those in high tax brackets. You can often use your leftover losses against other investment income when the costs of maintaining and renting a property plus depreciation total more than your taxable profit.
It's not actually a cash loss because depreciation isn't coming out of your pocket. It's a calculated number treated as an expense for tax purposes. You can still have a positive monthly cash flow while showing an operational loss for tax purposes.
You must pay property taxes if your business owns rental property, but you can deduct these taxes for income tax purposes. Businesses pay property tax on the assessed value of their real estate in the same way that individuals pay property tax on the assessed value of their homes.
The tax for the year is distributed between the previous and new owners when real estate is sold during a taxing year. This percentage split is based on how much of the year you owned the property as compared to how long the previous owners had the structure.
Landlord insurance will help to cover the value of the building and functions much like standard homeowners property insurance. The policy will cover damage from tenants and losses from storms. If your property is in a high-risk area and exposed to flood, earthquake, and wildfire be sure to get the appropriate insurance to cover your investment.
If you do find yourself at a loss after an event you can apply to the Small Business Administration (SBA) Disaster Assistance program for a loan that will help repair the damage.
1031 Tax Deferred Exchange
You can sell a property at a profit and roll the proceeds into another property without having to pay a capital gains tax, but some very strict rules apply. According to the Internal Revenue Code, Title 26, Section 1031:
"No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment."
Property of "like-kind" means another real estate or property. However, it does not necessarily require a land-for-land or office-for-office exchange.
Few investment asset classes and strategies can compare with rental real estate. People need a place to live, and owning a home is not possible for or desired by everyone.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.