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Investing in Real Estate Series
PART 1
Measuring Value and Performance of Investment Real Estate
Cash flow is key in measuring value and performance of an investment property. While several other less involved methods may be used to determine value of property, cash flow analysis is the most precise and widely used among commercial real estate professionals and investors.
As property prices continue to rise, appreciation becomes a factor in valuation. But appreciation is speculative in that a “possibility” may exist for the property to increase in value during the holding period. Without a crystal ball to see the future, appreciation is less easy to measure and must be predicted as a statistical “probability” based on historical trends in a given market place or location. We’ve all seen appreciation occur in growth markets. But to be a successful real estate investor you need more than luck of being at the right place at the right time. Savvy investors view appreciation as a “bonus” and not a good measure of valuation for investment property.
Comparing sales prices of similar properties is another way to determine value. This gives an investor a feel for market trends. Often a price per square foot comparison or price per unit comparison is used with this method. But this approach is limited because it disregards the income of the property. Moreover, certain specialty properties may not have any direct comparables.
The Gross Rent Multiplier method of estimating value is often widely used but seriously flawed. This method has numerous limitations, the least of which requires the investor to know what “multiple” is “normal” in a given market. But more importantly, the gross rent multiplier method does not take into account vacancy losses and other expenses such as utility bills, which may seriously erode the property’s cash flow.
“Investment value” is what an investor is willing to pay for a property. Investment value is unique to each individual investor, depending on the perspective, risk tolerance, and objectives of the investor. Investors typically are interested in cash flow performance. One of the first steps in the evaluation process in calculating investment value is to determine the cash flow from the operations, or the net operating income (NOI). The NOI is readily measured and sometimes called a property’s “dividend.”
Calculating NOI: NOI is calculated by subtracting operating expenses from the “scheduled” gross revenue. Calculations typically are done on a “annualized” basis. The gross income of a property is its potential income. For example, a rental property has gross income of $2,000 per month or $24,000 per year. To calculate “effective income” losses for vacancy must be deducted. Then deduct the “operating expenses,” which are the expenses the IRS allows-- real estate taxes, insurance, utilities, maintenance, advertising, management fees, etc.-- from the effective income. The resulting balance is the NOI. Let’s say that the NOI for the sample property equals $14,400.
Professional appraisers and many real estate professionals capitalize the income stream or NOI of a property to determine its value. A capitalization rate (cap rate) is a percentage that relates the value of an income-producing property to its future income, expressed as NOI divided by price. Cap rates can be tracked in a given market by keeping records of NOI calculations and sale prices of income producing properties. For instance, in Helena many duplexes have sold in 2004 with cap rates in the 6.4% to 7.5% range. Four-plexes have sold with cap rates only slightly higher, up to 8.5%.
Calculating Cap Rates: In the previous example if we use a market cap rate of 8% with an NOI of $14,400, the property’s value would be $180,000 (NOI divided by cap rate). If an investor negotiated a purchase price of $170,000 for the same property with a NOI of $14,400 the cap rate would be 8.47% (NOI divided by price). If the NOI remains constant, cap rates rise as the sales price falls. And conversely, cap rates fall as prices rise. Cap rates also may be a measure of risk. Investors may require higher cap rates if the risk is higher to maintain a reported cash flow. For example, older buildings may have unforeseen future maintenance expenses or an unexpected vacancy may reduce the NOI.
Although the capitalization method gives an investor a simple way to calculate a value it does not take into effect financing (debt service) or the tax impacts. The cap rate method only looks at one year of cash flow performance.
Investment properties must have enough cash flow to service the debt, if any, in order to pay a dividend. Cash-on-cash is another method that takes debt service and initial investment capital into consideration. This method calculates a yield percentage based on the initial cash investment (down-payment) and the cash flow before taxes (NOI less debt service).
Calculating Cash-on-Cash Return: For example if the sample property noted above was purchased for $180,000 with 20% down-payment or an initial investment of $36,000. Once the loan payments are calculated, subtract the annual debt service from the NOI. For example if the debt service was $10,922 the cash flow before taxes would be $3,478 (NOI-debt service ~ $14,400-$10,922) and the cash-on-cash yield would be 9.66% (cash flow before taxes divided by initial investment ~ $3,478 divided by $36,000). This method still is limited in that it does not consider tax impact. Moreover, not all investors will finance a property the same way.
A good rule of thumb for evaluating cap rate and cash-on-cash percentages is to compare them to the cost of money. The cost of money is generally the interest rate the lender will charge for the various loan packages available to finance the property. If the cap rate and the cash-on-cash percentages exceed the cost of money, the property may be worth consideration. But further scrutiny and analysis may be necessary before a decision should be made to buy. Other more in-depth analysis include: internal rates of return, net present value and capital accumulation comparisons. All of which require a deeper look at the objectives and characteristics of the individual investor.
Investment value is what an investor is willing to pay for the property to achieve a required return on investment, including target yield and/or tax objectives. When deciding to invest in real estate be sure to consult a real estate professional who can assist you with the process.
Stay tuned the next column in the series will discuss how you can determine your risk tolerance for real estate investments and how to measure and manage risk associated with owning investment real estate.
Randall Green
Real Estate Broker
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