Valuing Investment Property
Analyzing the real estate investment's value is similar to the fundamental analysis of stock valuation. However, real estate investment is not a quick-term trade. Therefore, it is essential to analyze the cash flow and subsequent rate of return to make profitable investments.
Investors must value real property and make educated guesses as to how much each one will bring in profit. This could be through rental income, property appreciation, or both. Investors can make better decisions about buying or selling the property if they have accurate real estate valuations.
Two basic methods are used to value equity: absolute and relativity. This is also true for real property valuation.
The discount rate used to calculate future net operating income (NOI) is the same as discounted cash flow (DCF), stock valuations. In real estate, the integration of the gross income multiplier model is comparable to stock relative value valuations. We'll be looking at these methods to value real estate properties.
The Capitalization Rate
One of the most critical assumptions when valuing real estate is to select an appropriate capitalization rate, also known as the cap rate.
Capitalization rate is the required return on real property, net of any value appreciation or depreciation. It is simply the rate applied to NOI to determine the current value of the property.
The capitalization rate is one key measure that can be used to value income-generating properties. It is more complicated than calculating the average cost of capital (WACC), but investors have several options to determine the appropriate capitalization rate.
Method of build-up
Market-extraction method
Band-of-investment Method
The Build-Up Method
The build-up method is a common way to calculate the cap rate. Add the following to the interest rate.
Proper liquidity premium --is a result of the illiquid nature of the real estate
Recapture premium accounts to net land appreciation
Risk premium - shows the total risk exposure of real estate markets
A 6% interest rate, 1.5% non-liquidity, 1.5% premium and 2.5% risk rate make the capitalization rate for equity property 11.5% (6% + 1.5%+ 1.5% + 2.5%). The property's market value is $1,739 130 if the net operating income is $200,000 (or $0.115).
This calculation is easy to do. It is not difficult to calculate the capitalization rate's components. The build-up method has the advantage of accurately measuring and defining individual components of a Discount Rate.
Market-Extraction Method
Market-extraction assumes that current, easily accessible NOI and sales price information is available on the comparable income-generating property. Thus, the capitalization rate gives direct income capitalization a greater meaning. This is the advantage of the market extraction method.
It is easy to calculate the capitalization rate. An investor might purchase a parking lot that is expected to bring in $500,000 per year. There are currently three parking lots that produce similar income in the vicinity:
Parking lot 1 has an NOI of $250,000 and a price of $3,000,000. Capitalization rate: 8.33% ($250,000/$3,000,000).
Parking lot 2 has an NOI of $400,000 and a price of $3.95million. Capitalization rate: 10.13% ($400,000 / 3,950,000).
Parking lot 3 has an NOI of $185,000 with a sale price of $2 million. Capitalization rate: 9.25% ($185,000/$2,000,000).
An overall capitalization rate will be 9.24% if you take the average cap rates of these three properties. This is a fair representation of the market. Investors can calculate the market value of the property by using this capitalization rate. The parking lot investment opportunity's value is $5,411,255 (500,000 / 0.0924).
The Band-of-Investment Method
The band-of-investment approach calculates the capitalization rate by using the individual interest rates applicable to properties with both debt and equity financing. This method has the advantage that it provides the best capitalization rate for real estate investments.
First, calculate a sinking funds factor. This is the amount that must be saved each time you want to have a certain amount at a later date. For example, let's say that property worth $950,000 has 50% financing. This is done using 7% interest and amortized for 15 years. The rest of the amount is paid with equity at a 10% required rate of return.
Valuation Methods
Absolute valuation models calculate the future value of future cash flows to determine the intrinsic value of an asset. The discount model and cash flow are the most popular.
On the other hand, relative value methods suggest that securities of similar earnings should be priced similarly. To determine if a stock's value is too high or low, ratios such as price to earnings (P/E) and price to sales are compared with other companies in the same industry.
Real estate valuation analysis should use both equity valuation and real estate valuation methods to establish a range.
Future NOIs Discounted
The NOI is the net earnings after taking into account operating expenses but before deducting taxes and interest. This is because the total revenue from the investment must first be calculated before subtracting expenses.
Based on similar properties, it is possible to forecast rental revenue in the beginning. An investor can use market research to determine the prices that tenants pay in the area. This will allow them to assume that the property can receive similar per-square-foot rents. The formula calculates the growth rate to account for future rent increases.
High vacancy rates can pose a threat to real estate investment returns. Therefore, a sensitivity analysis should be performed to determine the lost income, or conservative estimates should suffice.
Operating expenses are those directly incurred by the day-to-day operation of the building. These include property insurance, management fees, and utility costs. Depreciation is not included in the total expense calculation. Therefore, the net operating income for real property is the earnings before interest taxes, depreciation, and amortization (EBITDA).
The cap rate is used to discount NOI from real estate investments. This is similar to discounting future dividend streams by the appropriate rate of return, adjusted for dividend growth. This resemblance should be immediately apparent to equity investors who are familiar with dividend growth models.
Multiplier Of Gross Income
The Gross Income Multiplier Approach is a relative Valuation Method that assumes that property in the same area will be valued according to the Gross Income they generate.
Gross income, as the name suggests, is the income before operating expenses are deducted. Therefore, to get an accurate gross income estimate, it is necessary to forecast vacancy rates.
A real estate investor might purchase a 100,000-square foot building. They may find that the average gross monthly earnings per square foot of the area are $10. The investor might initially assume that the gross income per year is $12 million ($10 x 12 months x 100,000 sq. There are likely to be vacant units within the building at any time.
If there is a 10% vacancy rate, the gross annual income would be $10.8 million ($12million x 90%). Similar methods are used to calculate net operating income.
To determine the property's value, the next step is to calculate the gross income multiplier. This multiplied by the gross annual earnings will give you the gross income multiplier. You can find the gross income multiplier by looking at historical sales data. The average multiplier is calculated by taking the sales prices for comparable properties and multiplying that number with the earned gross annual income.
This valuation method is similar to using comparable transactions or multiples to value a stock. For example, analysts will often forecast earnings and multiply the earnings per shareholder (EPS) by the industry's P/E ratio. Similar methods can be used to value real estate.
Roadblocks To Real Estate Valuation
These two methods of real estate valuation seem fairly straightforward. In practice, however, these methods can be quite complicated in determining the income-generating property's value. It can be difficult and time-consuming to get all the information required about the formula inputs, such as net operating income and premiums in capitalization rate.
Second, these valuation models don't correctly account for significant changes in real estate markets, such as a credit crunch or an exploding real estate market. Further analysis is required to predict and factor in changing economic variables.
The property market is less liquid and transparent than the stock exchange, so it can sometimes be challenging to get the information you need to make an informed investment decision.
This being said, the large capital investment required to buy a significant development can make this complex analysis pay off if it leads you to an undervalued property (similarly to equity investing). Therefore, it is worth taking the time to find the right inputs.
The Summary
Many strategies used to value real estate are similar to equity analysis. However, other methods can be used in addition to the gross income multiplier and discounted NOI. For example, some industry experts have a working knowledge of development patterns and city migration.
They can then determine which areas will experience the highest rate of appreciation. Whatever the approach, research is the best predictor of success.
