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You can use one of a variety of approaches to analyze a real estate investment, or you can use a combination of approaches. It's just as important to choose the right way to analyze a property as it is to carefully pick the right property, since the wrong approach can mean lost profits. Below is an overview of different approaches used to assess the value and returns on a property, with notes about any drawbacks to using a particular method.

One common approach is the sales comparison approach. When you compare the property you're considering purchasing with similar properties that have been sold recently, you can come up with an estimated value per unit or per square foot.

Another approach is using a gross rent multiplier to get a working estimate of value. This is usually the approach favored by investors who buy the same types of property over and over. They take the sale price and divide by monthly potential gross rental income to determine the value of the property based on the first year's potential for rental income. The drawback is that this approach only gives you an idea of the value for the first year, and it only works if you're careful to compare properties that will have similar occupancy rates and similar expenses for operation.

Looking at cash invested (not including borrowed money) in relation to the first year's pre-tax cash flow is known as the cash on cash method. This approach involves determining the before-tax cash flow, which is net operation income (NOI) minus debt service and reserves. Next, you would divide this number by the amount invested in a down payment.

The advantage of this method is that it takes into account the impact of owner financing, operating expenses, gross rents and other non-rental income, vacancy rates and credit losses. The drawback to this approach is that, like the gross rent multiplier method, it is only a snapshot of the first year.

The cash on cash approach also does not factor in issues such as tax implications or property depreciation and appreciation. It also doesn't address the changes to the value of the dollar over time (often referred to as "time value of money" or TVM). While a property with a high cash on cash return might look attractive, another property with a lower cash on cash return might be a better bet if the future appreciation in that market is projected to be steadier.

 Like the cash on cash approach, direct capitalization (cap rate) starts with the NOI, but it is divided by sales price. The rate is a percentage of the price a potential investor will pay for the property. The advantage of this approach is that it considers operating expenses, gross rents and non-rental income, credit losses and vacancy. The downside is that it, too, only gives a picture of the first year. It doesn't take into account TVM, owner financing, the impact on taxes, or the depreciation or appreciation of the property.

Determining the property value by examining a variety of factors and using several different approaches may improve the accuracy of the calculation. One way to do this is demographic/trends analysis. This approach considers past and present trends to determine whether the property is-or can be- attractive to future buyers. By considering economic indicators, construction trends, and the types of people who are current or potential buyers, you can project whether the property has the potential to appreciate or whether it will become less attractive to buyers over time. Out-of-date properties or features of the property and general market demand will affect appreciation or depreciation. How rare the property is in the existing market will also affect future increases or decreases in demand for it.

Additionally, the demand for your property will be affected by any new construction being planned in the same market. One caution: to successfully use this approach, you must have firsthand experience in the market you're dealing with. A valuable resource for those wanting to try this approach to investment analysis is The Economic Trends Report.

Unlike some of the approaches listed above, the following three all look at the tax implications, TVM and mortgage debt service.

The first approach measures the average annual percentage earned on each dollar for entire time the dollar remains invested in the property. This is the internal rate of return (IRR). Using the initial amount invested and projecting it after tax cash flows and after tax sales proceeds determines the rate. There are a few drawbacks to this method. The method only calculates the return as long as the dollars stay in the investment and doesn't reflect reinvested returns. Also, one really good average annual return may give an overly optimistic picture if the investor spreads it out across several years to get a long-term estimate. The method can't take into account the initial investment being phased over time, nor can it reflect the impact of negative cash flow in the future. It also requires the investor to guess at how many future sales would bring in.

The second of these methods determines the value of an investment by adding the present value of all future cash flows compared to the initial cash investment. Using after tax annual cash flow and after tax sales proceeds, this approach is the net present value (NPV) of discounted cash flows. When the investment goes above investor expectations for a good annual return, the NPV is high. The approach can be used for making comparisons, such as whether it's wiser to invest in stocks and CDs or in real estate. Similar to the IRR, this approach has the drawback of not taking into account money reinvested during a given holding period.

An approach that does take into account the both the dollars that remain in the investment and money reinvested is called capital accumulation. With this method, you can compare two or more investments in terms of total accumulation of dollars rather than just on the rate of return on dollars that remain invested during the entire holding period. The limitation of this approach is that you must make assumptions, which could turn out to be false, about potential sales price as well as future returns of competing investments.