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Real estate investors must have basic valuation skills to make buy,
sell, or hold decisions. Real estate investment companies have developed
sophisticated valuation models to aid them in
making investment decisions. However, by using spreadsheet tools an
individual can produce an adequate valuation on most income-producing
real estate. This would include residential real estate purchased
as residential rental property.
SEE: 3 Ways To Value Real Estate Investments
Valuing real estate using
discounted cash flow or
capitalization
methods is similar to valuing stocks or bonds. The only difference is
that cash flows are derived from leasing space as opposed to selling
products and services. Read on to find to out how any
investor can create a valuation satisfactory enough to weed through prospective investment opportunities.
Individual Valuations
Some individuals feel that producing a valuation is unnecessary if a certified
appraisal
has been completed. However, an investor’s valuation may differ from an
appraisal for several reasons. The investor may have different opinions
about the property’s ability to attract
tenants
or the lease rates that tenants are willing to pay. As a prospective
purchaser or seller, the investor may feel that the property has more or
less risk than the appraiser. Appraisers are compelled to conduct
separate assessments of value. They include the cost to replace the
property, a comparison of recent and comparable transactions and an
income approach. Some of these methods commonly lag the market,
underestimating value during uptrends, and overvaluing
assets in a downtrend.
Finding opportunities in the real estate market involves finding properties that have been incorrectly valued by the
market.
This often means managing a property to a level that surpasses market
expectations. A valuation should provide one’s estimate of the true
income-producing potential of a property.
Real Estate Valuation
The income approach to evaluating real estate is similar to the
process for valuing stocks, bonds, or any other income-generating
investment. Most analysts use the discounted cash flow (
DCF) method to
determine an asset’s net
present value (NPV)
. NPV is the property value in today’s dollars that will achieve the investor’s
risk adjusted return.The NPV is determined by discounting the periodic cash flow available to owners by the investor’s
required rate of return (RROR).
Since the RROR is an investor’s required rate of return for the risks
involved, the value derived is a risk-adjusted value for that individual
investor. By comparing this value to market prices, an investor is able
to make a buy, hold, or sell decision.
Stock values are derived by discounting
dividends, bond values by discounting interest
coupon payments. Properties are valued by discounting net
cash
flow or the cash available to owners after all expenses have been
deducted from leasing income. Valuing a property involves estimating all
the rental
revenues and then deducting all expenses required to execute and maintain those leases. (For tips, check out
Golden Opportunity For Real Estate Investors.)
All income estimates come directly from leases. Leases are contractual agreements between tenants and a
landlord.
All rent and contractual increases in rent (escalations) will be
spelled out in the leases, as well as options for space and rent
concessions. Owners also recoup part or all of the property expenses
from tenants. The manner in which this income is collected is also
stated in the lease contract. There are three main types of leases:
In full-service leases, tenants do not pay anything in addition to
rent. In net leases, tenants usually pay their portion of the increase
in expenses for the period after they move into the property. In
triple-net leases, the tenant pays a
pro-rata share of all property expenses.
The following are the types of expenses that have to be considered when preparing an income valuation:
Leasing costs refer to the expenses necessary to attract tenants and
to execute leases. Management costs refer to property level expenses,
such as utilities, cleaning,
taxes, etc. as well as any costs to manage the property. Income less
operating expenses equals
net operating income (NOI).
NOI is the cash flow derived from normal operations of the property.
Cash flow is then derived by subtracting capital costs from NOI. Capital
costs are any periodic capital outlays to maintain the property. These
include any capital for leasing commissions, tenant improvements, or
capital reserves for future property upgrades. (Check out
Closing A Real Estate Deal In A Down Market.)
Valuation Example
Once periodic cash flows are determined, they can be discounted
back to determine property value. Figure 1 shows a simple valuation
design that can be adjusted to value most properties.
Assumption |
Value |
Assumption |
Value |
Growth in Income Yr1-10 (g) |
4% |
Growth in Income Yr11+ (g) |
3% |
RROR (K) |
13% |
Expenses % of Income |
40% |
Capital Expenses |
$10,000 |
Reversion Cap Rate (K-g) |
10% |
The valuation assumes a property that creates annual rental income of
$100,000 in year one, which grows by 4% annually and 3% after year 10.
Expenses are estimated at 40% of income.
Capital reserves
are modeled at $10,000 per year. The discount rate, or RROR, is set at
13%. The capitalization rate for determining the reversion value of the
property in year 10 is estimated at 10%. In
financial terminology, this
capitalization rate
equals K-g, where K is the investor’s RROR (required rate of return)
and g is the expected growth in income. K-g is also known as the
investor’s required income return, or the amount of the total return
that is provided by income.
The value of the property in year 10 is derived by taking the
estimated NOI for year 11 and dividing it by the capitalization rate.
Assuming the investor’s required rate of return stays at 13% then the
capitalization would equal 10%, or K-g (13% -3%). In Figure 2, NOI in
year 11 is $88,812. After periodic cash flows are calculated, they are
then discounted back by the discount rate (13%) to derive the NPV of
$58,333.
Item |
Yr 1 |
Yr 2 |
Yr 3 |
Yr 4 |
Yr 5 |
Yr 6 |
Yr 7 |
Yr8 |
Yr 9 |
Yr 10 |
Yr 11 |
Income |
100 |
104 |
108.16 |
112.49 |
116.99 |
121.67 |
126.54 |
131.60 |
136.86 |
142.33 |
148.02 |
Expenses |
-40 |
-41.60 |
-43.26 |
-45 |
-46.80 |
-48.67 |
-50.62 |
-52.64 |
-54.74 |
-56.93 |
-59.21 |
Net Operating Income (NOI) |
60 |
62.40 |
64.896 |
67.494 |
70.194 |
73.002 |
75.924 |
78.96 |
82.116 |
85.398 |
88.812 |
Capital |
-10 |
-10 |
-10 |
-10 |
-10 |
-10 |
-10 |
-10 |
-10 |
-10 |
- |
Cash Flow (CF) |
50 |
52.40 |
54.90 |
57.49 |
60.19 |
63 |
65.92 |
68.96 |
72.12 |
75.40 |
- |
Reversion |
- |
- |
- |
- |
- |
- |
- |
- |
- |
888.12 |
- |
Total Cash Flow |
50 |
52.40 |
54.90 |
57.49 |
60.19 |
63 |
65.92 |
68.96 |
72.12 |
963.52 |
- |
Dividend Yield |
9% |
9% |
9% |
10% |
10% |
11% |
11% |
12% |
12% |
13% |
- |
Figure 2 (in thousands of dollars) |
Figure 2 provides a basic format that can be used to value any
income-producing or rental property. Investors purchasing residential
real estate as rental property should prepare valuations to determine
whether rental rates being charged are adequate enough to support the
purchase price being paid. Although appraisers will often use a 10-year
cash flow by default, investors should produce cash flows that mirror
the assumptions on which the property is assumed to be purchased. This
format, although simplified, can be adjusted to value any property,
regardless of complexity. Even hotels can be valued this way. Just think
of nightly room rentals as one-day leases.
SEE: Real Estate Deal-Breakers That Shouldn’t Be
Buy, Sell or Hold
When purchasing a property, if an investor’s assessed value is
greater than the seller’s offer or appraised value, then the property
can be purchased with a high probability of receiving the RROR.
Conversely, when selling a property, if the assessed value is less than a
buyer’s offer, the property should be sold. In addition, if the
assessed value is in line with the market and the RROR offers an
adequate return for the risk involved, the owner may decide to hold the
investment until there is a
disequilibrium between the valuation and market value.
Value can be defined as the greatest amount that someone would be willing to pay for a property. When purchasing an asset,
financing
should not affect the ultimate value of the property because each buyer
has different financing options available. However this is not the case
for investors who already own properties that have been financed.
Financing
must be considered when deciding on an appropriate time to sell because
financing structures, such as prepayment penalties, can rob the
investor of his or her sale’s proceeds. This is important in cases where
investors have received favorable financing terms that are no longer
available in the market. The existing investment with debt may provide
better risk-adjusted returns than can be achieved when reinvesting the
prospective sales proceeds. Adjust risk RROR to include the additional
financial risk of mortgage debt.
The Bottom Line
Whether buying or selling, it is possible to produce a
valuation model accurate enough to assist in the decision-making
process. The math involved in creating the model is relatively
straightforward and within the grasp of most investors. After gaining
some rudimentary knowledge about local market standards, lease
structures and how income and expenses work in different property types,
one should be able to forecast future cash flows.
READ MORE: Homeowners, Beware These Scams!
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