Real Estate and the Role of Financial Analysis: Trends to Watch Out For
Real Estate Financial Analysis is a process that involves studying and evaluating the performance of real estate properties to make informed decisions about investment, development, and management. These businesses usually fall into four categories: commercial, residential, industrial, and investment lands. The analysis further divides these businesses into cash flows, future benefits, and tax effects for proper and detailed financial analysis. In this article, we have discussed the role of economic analysis in the real estate industry and, more specifically, the trends to watch out for in 2023.
One of the most critical aspects of financial analysis in real estate is cash flow analysis. This involves analyzing a property or portfolio’s revenues, expenses, and other inflows and outflows. Cash flow is an essential indicator of how profitable a real estate investment will be. Moreover, it can help investors assess the risk and potential investment return. The amount generated comes after subtracting all the costs incurred by the particular property. These are annual cash flows; however, sometimes, they can be in a monthly format.
Tax is a vital part of any business structure. For example, in real estate analysis, the tax affects the cash flow received after the annual term. The government collects these taxes as capital gains or rental income tax, depending on the nature of the business.
Future advantages (capital gains/loss) are how the position of an investor’s capital changes within the annual term after the deduction of tax.
These three essential parts help determine a real estate property’s value and yearly income/loss. In the sections ahead, we will discuss the importance of these parts and how a real estate financial analyst examines and analyzes them. We will also discuss new trends in the real estate business and what things to look out for when investing in a property.
Financial Analysis in Real Estate
Investors hire financial analysts to trace trends from the past on property/s in a particular location/s. These trends reflect the valuation of the property. The most commonly used process for property valuation is known as the setup. It is a combination of cash flow statements and income statements. Part one determines the value of a property before taxation, and part two determines the value after tax.
Elements of Setup
The setup has different factors that determine the value of a property. These include gross revenue, operating expenses, mortgage interest, vacancies, repairs, etc. A real estate financial analyst designs the structure of a property based on these assumptions.
Impact of Financial Analysis on Real Estate
With all the data presented to a financial analyst, they can research different methods to improve the investor’s capital invested. The two most important and widely used methods are the leverage concept and the valuation model.
Leverage is the amount of debt borrowed to fund an asset.
Real estate is a safe investment with a debt-to-equity ratio higher than other assets. The accepted ratio is 60% debt and 40% equity. In less risky investments, debt can be as high as 75%. Financial leverage offers a better return to the investor on their investment as long as it provides positive leverage (yearly income is higher than annual debt payment). A financial analyst covers the data to find what debt-to-equity ratio would be most promising for any particular investment.
The value of a property refers to the amount of money a buyer is willing to pay to acquire the asset. Several factors connect to define the value of a property. First, analysts use capitalization techniques to assess income-generating properties. The formula is annual cash flow divided by the capitalization rate.
For example, the yearly cash rate of a property through rental income is $100,000, with a capitalization rate of 6.25%. Therefore, the value of this property equals $1,600,000.
Thus, a small cap rate will generate higher property value. Real estate financial analysts use this method to understand overvalued or undervalued properties. This method also illustrates the best annual rental yield-producing properties.
Types of Real Estate Businesses and their Financial Models
Real estate uses different ratios and analysis techniques according to the business model. So let’s examine how these business models use strategies to generate maximum profits.
House-flipping is when an investor buys a particular property, keeps it for a short period, makes particular renovations to it, and then sells it for a profit. This business makes significant returns in a limited time frame. But how does one get the best deal and make the most out of it?
Financial Analysts use the Maximum Allowance Offer (MAO) formula to calculate the worth of an unrenovated property. First, they find an After-Repaired Value (ARV) of the property, what it will be worth after the renovations, minus all the costs it would take to bring up the value. After that, you present your MAO at approximately 65 to 70% of the after-ARV minus cost value.
For example, a property that needs renovation has an ARV of $1,000,000. The cost of repairs is $120,000, and there is an outstanding loan of $30,000 on the property. Therefore, the ARV minus the cost value of the property stands at $850,000. You multiply it by 70% to get the Maximum Allowance Offer for that property which is $595,000, and you make a profit of $255,000.
House-flipping can sometimes be risky based on the market conditions and if there are any significant economic issues around people, such as inflation or rising interest rates.
Real Estate Property Management
A real estate property manager is responsible for looking after the properties of various investors for a yearly commission. In addition, the manager supervises any repairs or renovations that a property requires. A real estate broker manages the property and looks after rent payments, property listing, and marketing. In general practice, a real estate broker is paid a 2% commission on the sale of a listing and 5% on rentals.
Real Estate Appraisal
An appraisal profession requires a real estate or financial management degree. Their job description is to visit approved listings and generate a market value. Then, based on their findings, they propose a deal to the hiring agent.
Real Estate Investor
An investor’s primary job is to find the best deals to invest their capital. They can buy a property, negotiate prices, use appraisers to value their assets and market their listings. These investors hire financial analysts on different occasions in the dealing process from the beginning to the end.
They can work as sole investors or form a partnership. In addition, they may begin a real estate investment trust (REIT) or a real estate investment fund (REIF), depending on the amount of capital or the number of investors they can manage.
In the global economic crisis with higher interest rates and currency devaluation, the emerging trend is careful investments with little hope that the market will rise again. Following the housing market crisis in 2008, this is the second time the world is seeing a housing market crash. Although the reasons today are entirely different from what they were in 2008, investors face the same intense pressure on their assets with zero liquidity.
With that, there are several changes in the housing market’s future trends.
Many people are shifting to more affordable housing plans. Many Americans have stopped spending their lives hoping to live the American dream. People are even moving into tiny homes, also known as micro-homes, that are the size of studio apartments. One reason for this shift is the lack of affordable housing in the market.
Another reason is the shortage of construction workers in first-world countries. As a result, property developers, who can find workers and bring in affordable housing plans, have an arbitrage opportunity to provide people with homes making a reasonable profit.
Work from Home
The post-pandemic scenario in the workforce is developing a new strategy for employees to work from home. This concept is the reason why many office spaces are currently vacant. However, some large firms with enough capital to survive still hold office spaces to bring employees back to the office.
However, this is different with many small businesses. These companies have completely transformed into virtual businesses working from home to save electricity, rent, janitors, and transportation overhead costs. As a result, around 10 to 20% of office spaces are empty. There is no certainty on how this trend might come out in the future, even in the most optimistic scenarios.
Real Estate Capital Market
Since 2021, there has been a shift in investments from the housing market and stocks toward bonds and index funds. One primary reason for this shift is the volatility in the current market. High risks associated with these assets and limited expected return on investments make investors reluctant. In addition, prices are changing spontaneously, frightening the buyers that they might pay for an overpriced acquisition.
This phenomenon will only stop if the state bank stops raising interest rates to control public spending. Due to this increase, only a few investors seek a long-term approach to their assets. However, if the state bank keeps pushing the interest rate, they might back off.
Metaverse is the latest trend in the real estate market. It is a solid concept to develop this world in a virtual village. All the conferences, talk shows, and exhibitions are turning towards online gatherings. In addition, it has made it more straightforward for employers to evaluate employee performance through various digital mediums.
Although this is an excellent achievement for development in many sectors, it might change how we look at the real-world. The real-time experiences and interactions through meetings, events, conferences, etc., today have an entirely different approach.
Metaverse has its benefits. It develops a platform to buy and sell virtual real estate properties. There is no physical property involved. As a result, many investors can benefit from it.
Climate Change in Real Estate
Environmental, Social, and Governance (ESG) are a set of rules and regulations set by the government for companies to follow. These strategies try to improve a company’s approach toward the betterment of society.
Climate change is accurate and can be seen in the floods in south Asia. Therefore, the government advises construction companies to follow ESG policies strictly. These policies make cutting costs on various materials used to form properties challenging.
Trend Analysis in Real Estate
Trend analysis is a comparative market analysis examining various properties and their valuation changes over time. To stay ahead of competitors and make informed investment decisions, real estate companies increasingly rely on data-driven tools and techniques to track emerging trends in their industry. These include big data analytics, predictive modeling, machine learning algorithms, and online search patterns.
There are several benefits to performing trend analysis in real estate. Firstly, it enables companies to identify new opportunities for growth by tracking changes in consumer preferences and behaviors over time. Secondly, it allows them to identify areas where they may be under or over-investing based on macroeconomic factors such as inflation and interest rates.
It is essential to do market analysis as it helps one to understand the current trends in the business. Therefore, every real estate broker and agent must be capable of trend analysis to benefit their clients.
There are several reasons why trend analysis is essential in the current scenario.
With the increasing fluctuation in the prices of real estate properties, one should understand what location would be the best to invest in and what characteristics in a property determine its value. In addition, one should also have information about the latest developments and projects. This information would help them examine the difference between the prices of newly-constructed and old-renovated assets.
How does a Financial Analyst Evaluate Trend Analysis in Real Estate?
There are six steps that financial analysts use to figure out a trend.
Step 1) Market Study in Real Estate
The market study is the first step in forming an analysis of real estate. Through this stage, a financial analyst looks at macroeconomic perspectives like evolution and economic change. They also study the shift in consumer behavior and offers given to them by competitors. This stage helps them research the market situation and involved competitors.
Step 2) Customer Demand
This stage examines what a customer wants. An analyst studies these customers through different demographics such as their age, income level, how much they are willing to pay, their location, and the number of customers increasing or decreasing. This stage examines a customer’s potential in a particular market.
Step 3) Real Estate Offer Price
This stage mainly concerns competitors—their offerings for a specific location and what customers they target. Next, an analyst looks for the most prominent players and their target locations.
Studying competitors and their offerings will clarify the opportunities or threads you may encounter.
Step 4) Legal Issues and Social Environment
One needs to understand the environment to minimize the risk of external involvement in the business structure. For example, there can be communities whose social norms might differ from your business practices. A slight difference in legal regulations for specific locations is also possible. Consideration of all these factors is crucial in the real estate industry.
Step 5) Data Collection
Data collection is when a financial analyst must be as accurate as possible. Every single transaction involved in the process is to be collected and managed. For example, the prices offered, renovation costs (if any), transportation, surveys, etc. A good quality data collection process will be collateral for your investments.
Step 6) Final Results
A financial analyst presents the results from their findings to the investor. The investor then works on a feasibility report with the analyst for the best investment possible. If the information is justified, the investor will decide to put money into a property or a location.
Benefits of Real Estate Financial Analysis
For a company to keep moving in a business environment, the officials need to have a transparent look at its financial status. A financial analyst evaluates the company’s financial position through various metrics, methods, and digital programs to identify where it lies in a market. The analysts work on income statements, cash flows, balance sheets, and CFO dashboards. These statements go through examinations and cross-checking to find insights and trends in which a company can invest. Analysts present companies with real-time information with teachings from the past. These companies also use financial analysis in real estate to find their standing on debt and leverage positions.
A prominent financial analyst will improve connections between investors, buyers, potential partners, and banks. This relationship becomes the groundwork for a strong business plan with minimum diversifiable risk.
Real estate has always been a lucrative market for long-term investors. It is considered one of the safest industries to invest money in. The financial analysis in real estate examines a company’s accounts framework and capital stability. These analyses come with different trends and methods that differ for every location.
Real estate investors must watch out for all the financial analysis techniques used in the business world to achieve maximum return on investment. Modern analysis techniques will help them determine what locations or properties to look for investment opportunities.
The only way to drive favorable outcomes in the ever-changing property market is to go for professional financial analysis. So if you want to make the best investment in real estate, contact us today, and our team will perform an in-depth analysis for you.