Approaches to Analyzing a Real Estate Investment

Since every investor has a different cost of capital and different short and long-term goals it is important to select the approach that makes sense for your situation.

 

Here are a few approaches used to understand the value of your real estate investments. Since every investor has a different cost of capital and different short and long-term goals, it is important to select the approach that makes sense for your unique situation.

Sales Comparison Approach: Compares the subject property to similar properties recently sold and calculates an average price per unit or square foot to determine value.

Gross Rent Multiplier: A rough estimate of value. Generally used by investors that repeatedly buy the same types of property. Take your Sale Price and divide by Monthly Potential Gross Rental Income. This method determines the value of a property based solely on potential rental income for the first year. Limitations: It reflects a one-year snapshot in time. It only helps to compare properties that have very similar operating expenses and have similar occupancy/vacancy rates.

Direct Capitalization (Cap Rate): Take Net Operating Income (NOI) and divide by Sales Price. It is expressed as a percentage of the sales price offered, or a percentage of the price you are willing to pay. It accounts for operating expenses, gross rents, non rental income, vacancy and credit losses. Limitations: It is a one-year snapshot. It does not account for the present versus the future value of the dollar (time value of money), nor does it account for owner financing, tax implications, property depreciation and appreciation.

Cash on Cash: Looks at cash invested up front (not borrowed dollars), as related to the first-year cash flow before taxes. Divide Before Tax Cash Flow (NOI less debt service and reserves) by the amount of cash invested for your down payment. This method accounts for the impact of owner financing (investing with borrowed money). It also accounts for operating expenses, gross rents, non rental income, vacancy and credit losses. It is helpful since many investors do not use their own cash to buy property. Therefore, cash invested is a fraction of the full purchase price. Limitations: It is a one-year snapshot. It does not account for TVM, nor does it consider owner tax implications, or property depreciation and appreciation. When comparing properties in different areas, a property with a lower cash on cash return might be a better investment if the potential for appreciation is more predictable.

Demographic/Trends Analysis: Projects potential appreciation and potential obsolescence by closely examining economic indicators, building and demographic trends (profiles of current and future buyers). Property appreciation will be driven by overall demand and scarcity in the market and impacted by obsolete property or community features. It is important to know how rare a property is in the market and how likely demand for this property is to increase or decrease due to competing existing properties and planned new construction. The Economic Trends Report is a valuable resource for this approach. This approach answers the question: Does this property have or can it have what buyers will be looking for in the future? Limitations: You must have reliable first-hand experience in a given market.

The following approaches consider the time value of money (TVM) and the investor’s tax situation.

IRR or Internal Rate of Return: Measures the average annual yield (percentage earned) on each dollar for as long as it remains in the real estate investment (entire holding period). It uses the initial amount invested, projected after tax cash flows, and projected after tax sales proceeds. Limitations: Reflects the return as long as the dollars stay in the investment and does not take into account reinvested returns. It measures an average annual return over time, so across multiple years it may exaggerate the impact of a single year with a very high return. This method can’t account for negative cash flows in future years nor can it account for the initial investment being phased in over time. It also does not account for returned dollars being reinvested as they are returned. You must make assumptions about future sales proceeds.

Net Present Value of Discounted Cash Flows (NPV): Determines the dollar value of an initial investment by taking the sum of the present value of all future cash flows, netted against (or compared to) the initial cash investment. If NPV is high the investment exceeds investor expectations for a desired annual return. This approach uses after tax annual cash flow and after-tax sales proceeds. Often used to compare different types of investments. Limitations: Does not account for money reinvested during a given holding period.

Capital Accumulation: Considers return of and on investment in the circumstance where money returned is reinvested during the property’s entire holding period. Compares two or more investment alternatives in terms of accumulated dollars rather than rate of return. Accounts for dollars that remain in investment and those that are returned from the investment and reinvested. Limitations: You must make assumptions about the potential sales price, as well as the potential returns of competing investments over time.

Need more information about buying, selling or leasing? Call or email 203-570-2096 or prattray@wpsir.com

5 Fairfield County, CT Real Estate Myths That Won’t Go Away

Real Estate can be many things. It can be a home, an investment, a status symbol, a legacy and more. It can only work for you if you are clear about your objectives.

 

Here are a few myths that have been lingering around Fairfield County for years. Feel free to share your myths with me. I am happy to address them in a future blog.

Myth 1: Market and interest rate fluctuations directly impact your home’s value in the short-term
Fact: Market trends and buyer costs can have an influence on your home’s value in the long-term, but this influence is never greater than the features of your home such as size, materials, condition, location, floor plan, scarcity, style, etc. If you buy a style of home that is generally undesirable or you neglect to maintain or update your home on a regular basis, your potential for appreciation will be limited, regardless of what the market is doing.

Myth 2: A Realtor sets the list price of the house for the seller.
Fact: Recently closed transactions determine the fair market value of your home. This is what we think buyers are willing to pay in the current market. In Fairfield County, agents generally recommend a list price that is about 3% – 5% higher than market value, but sellers make the final decision. A seller can choose to list for less to create quick multiple offer situations. There is no evidence that either strategy is guaranteed to create a higher sales price. Many buyers refuse to take part in multiple offer situations and many sellers don’t necessarily want a quick sale. There is data that suggests that pricing excessively high (6% – 10% above market value) can lead to a lower sale price. Once a listing becomes stale, buyers tend to offer less and less over time.

Myth 3: Market conditions should determine when and what you should rent, buy or sell.
Fact: Your lifestyle and financial objectives should determine when and what you should rent, buy or sell. If you are buying a home as an investment, your approach, choice and timing should be completely different than if you are buying a home for lifestyle reasons.

Myth 4: There is an advantage to using more than one Realtor at a time.
Fact: In CT, all Realtors have access to all listed properties from all brokerages, so there are only disadvantages to using more than one realtor. These include lengthening the time it takes for a Realtor to understand your needs and increasing the risk that you will be late to the offer table. When you are represented by one Realtor, he or she becomes responsible for the significant due diligence and research required for finding and securing your new home.

Myth 5: There is one real estate market.
Fact: An experienced Realtor knows that you can’t characterize the entire real estate market in the country or even in a town. Investors, condo buyers, house buyers and sellers all have different needs and a good market for one group can be a terrible market for another. Similarly, if you plan to build or flip, market trends matter less than your specific financial model and the current demand for what you are building. The same is true if you plan to buy and hold a group of investment properties. You can find good long-term investments in any type of market. Just make sure you know how to make proper improvement, return, rent and vacancy projections.

Need more information about buying, selling or leasing? Call or email 203-570-2096 or prattray@wpsir.com