Unit 14 Determining Value & Profitability

Transcription

1 Unit 14 Determining Value & Profitability [istock_344223modified - duplex] [istock_ ] INTRODUCTION The value of a property and a profitable income stream are obviously important to a real estate investor. A property that combines both of these attributes is an asset to any real estate investment portfolio. In order to locate these types of properties, real estate investors must apply measurements that help analyze whether a property will put an investor s capital to good use. These measurements consist of income multipliers and direct capitalization. After purchase, an investor needs to evaluate a property s operations to determine whether the investment is profitable. Profitability measurements discussed include breakeven analysis, payback period, cash on cash return, net present value, and the internal rate of return. Learning Objectives After reading this unit, you should be able to: distinguish among the various types of income multipliers. specify the various capitalization rates, methods, and techniques. recognize different ways to measure profitability. Real Estate Economics, 2 nd Edition, 2 nd Printing 393

2 394 Real Estate Economics DETERMINING VALUE The methods primarily used to determine value include income multipliers and direct capitalization. Income Multipliers The key benefit of using a multiplier is its relative ease of use. A multiplier is a number that, when multiplied by the income, gives an indicator of value. The advantage of this method is that it is widely used and understood by both the investing public and the investment community. In order to use multipliers as means of deriving income to value, an investor needs to research the sale prices of similar properties, income, expenses, financing arrangements, and economic conditions of the real estate market at the time of sale. Inexperienced investors may make a mistake by using multipliers derived from properties that are not truly similar to the investment property. Care must be used to ensure the income or rent of the properties used to derive the multiplier is comparable to that of the investment. The specific multiplier has to be applied to the same income base. Gross Rent Multiplier The gross rent multiplier (GRM) is a figure which, when multiplied by the monthly rental income, will give an indication of the property s value. In a single-family residence investment that is tenant-occupied, the gross rent multiplier is applied to obtain the value. The GRM is also applied when analyzing other smaller incomeproducing properties such as duplex and fourplex units. The gross rent (GR) is income (calculated annually or monthly) received from rental units before any expenses are deducted. The GRM is also used in analyzing multiple-family residential and commercial properties. Formula Gross Rent Multiplier GRM = Value GR Value = GRM GR

3 Unit 14: Determining Value & Profitability 395 The gross rent multiplier is a factor of the ratio between gross rent and sales price. The gross rent multiplier for the investment property is estimated based on an analysis of the ratio between the sale price and gross rent for a number of similar properties. The sale price of a property is divided by its gross monthly rent to determine a gross rent multiplier factor. The rent multipliers of several comparable properties should be determined and analyzed to estimate the proper gross rent multiplier for the investment. Gross rent multipliers for single-family residences, duplexes, and small apartment buildings are usually expressed as a monthly multiplier factor. Multipliers applicable to large apartment buildings and commercial properties are expressed on a yearly income basis. The investor converts a monthly multiplier to an annual factor by dividing by 12. For example, a monthly multiplier of 130 would be the same as a yearly multiplier of The GRM is a reliable investment valuation tool when sufficient sales data are available. The gross rent for the property must be estimated from or substantiated by similar rental rates in the area. Many investors in small residential income properties, such as duplexes and fourplexes, rely strongly on the GRM when purchasing investment property. There are three main steps to apply when using the GRM: (1) select similar properties and calculate GRM, (2) obtain the mean for the comparable property data, and (3) apply the GRM to the investment property. First select similar properties and calculate the GRM for each. Once these properties are selected, determine which of these best resembles the investment property. Guidelines for Selecting Similar Properties Sales should be recent, and rent multipliers may change with economic conditions. Sale properties should be located in the same or equal neighborhoods as the investment property. Sale properties should be reasonably similar to the investment in all essential physical elements. Rent for the sale properties must be the fair market rent at the time of sale. Ratio of expenses to rent should be similar for the sale property and the investment.

4 396 Real Estate Economics Analyze the sale properties and select the multiplier to be applied to the investment property. After the GRM is derived from the sales of similar properties, it must be applied to the investment in the same manner as it was derived. The GRM is a ratio between price and income at the time of sale, and no adjustments are necessary. Example: An investment property is a fourplex located in a suburban neighborhood. There are two 1-bedroom/1-bathroom units and two 2-bedroom/1-bathroom units. The investor performed a rental survey and determined that the 1-bedroom units rent for $750 per month and the 2-bedroom units for $850 per month. The actual rents were reasonably close to the economic rents, but the investor used economic rents as this is proper investment practice. Investment Property Two Units $750 rent/month = $1,500 Two Units $850 rent/month = $1,700 Total Forecasted Monthly Income = $3,200 Step 1: Find Similar Sales and Calculate GRM GRM is found by dividing the sales price by the gross monthly rent. Sale #1 This property is a 5-unit apartment house with three units that are 1-bedroom/1-bathroom and two units that have 2-bedrooms/1.5- bathrooms. The 1-bedroom units rent for $725 per month and the 2-bedroom units for $875 per month. This property recently sold for $608,350. Three Units $725 rent/month = $2,175 Two Units $850 rent/month = $1,700 Total Forecasted Monthly Income = $3,875 GRM = $608,350 $3,875 = (rounded to 157) Sale #2 This property is a triplex with one unit that has 1-bedroom/1-bathroom and two units that have 2-bedrooms/1-bathroom. The 1-bedroom unit rents for $735 per month and the 2-bedroom units for $850 per month. This property recently sold for $433,400. One Unit $735 rent/month = $ 735 Two Units $850 rent/month = $1,700 Total Forecasted Monthly Income = $2,435 GRM = $433,400 $2,435 = (rounded to 178)

5 Unit 14: Determining Value & Profitability 397 Sale #3 This property is a fourplex with three units that have 1-bedroom/1- bathroom and one unit that has 2-bedrooms/1-bathroom. The 1-bedroom units rent for $750 per month and the 2-bedroom units for $875 per month. This property recently sold for $525,000. Three Units $750 rent/month = $2,250 One Unit $850 rent/month = $ 850 Total Forecasted Monthly Income = $3,100 GRM = $525,000 $3,100 = (rounded to 169) Step 2: Obtaining the Mean for Comparable Property Data The three comparable properties produced gross income multipliers that range from 157 to 178 (summarized on grid below). Commonly known as the average, the mean is calculated by adding the average prices or numeric values of a statistical sample and dividing that by the number of values in the sample. Sales Monthly Income Sales Price GRM Sale 1 $3,875 $608, Sale 2 $2,435 $433, Sale 3 $3,100 $525, Averages/Mean $3,137 $522, The investor thought that the sales were usable as they were all within six blocks of the investment property. He gave Comp 3 the most weight as it had the same number of units as the investment. Comp 2 had more curb appeal and two extra parking spaces, which put this sale at the upper limit of the value range. The investment property had some deferred maintenance which none of the sales had so the investor reconciled the GRM between Comps 1 and 3. The reconciled GRM was 163. Step 3: Derivation and Application After the GRM is derived from the sales, it must be applied to the investment in the same manner that it was derived. Value of the Investment Property = GRM x Gross Rent Value of the Investment Property = 163 x $3,200 Value of the Investment Property = $521,600

6 398 Real Estate Economics Gross Income Multiplier One of the simplest ways to form an opinion of a property s value based on its income is to use a gross income multiplier (GIM). A gross income multiplier (GIM) is a figure which, when multiplied by the annual gross income, will equal the property s value. The GIM is generally reserved for larger incomeproducing and commercial properties. The gross income multiplier (GIM) is similar to the GRM method. The distinction between the two is that GIM accounts for all possible potential income, whereas GRM accounts only for the property s rental income. It is faster to calculate the GRM, but consequently, it is not as accurate or detailed as the GIM. Like GRM, the amount of the GIM must be obtained from recent sales since it varies with specific properties and areas. The potential gross income multiplier (PGIM) is the ratio between the value or sales price of a property and its potential gross income. Potential gross income (PGI) is the amount of income a property could potentially generate assuming 100% occupancy at market rental rates. Derivation and Application To derive a GIM, the investor must have data of similar properties that were rented at the time of sale, or were anticipated to be rented within a short time period. The GIM used to value the investment property is estimated based on an analysis of the ratios between the sales prices and gross incomes for a number of similar properties. The sale price of a property is divided by its gross monthly rent to determine a gross income multiplier (GIM). Gross income multipliers can be used with either monthly or yearly income. Monthly income is used primarily when analyzing small multi-family residential properties or in cases where there are no seasonal variations in a property s projected income. In most situations, an investor uses the annualized income multiplier. Review GRM vs. GIM Gross rent multiplier (GRM) is used only with rental income. Gross income multiplier (GIM) suggests that some of the income used comes from sources other than rent.

7 Unit 14: Determining Value & Profitability 399 Effective Gross Income Multiplier (EGIM) Another ratio that an investor can use is the effective gross income multiplier (EGIM). The effective gross income multiplier (EGIM) is the ratio between the effective gross income and the value of the property. Effective gross income (EGI) is the amount of income remaining after vacancy and credit losses are deducted from gross income. It is especially important for the investor to be sure the potential income and vacancy factor for each of the sales used is calculated in the same manner as it is for the investment. An income multiplier derived from potential income can only be applied to the potential income of the investment. The same is true for income derived from effective gross income. This process can be used for all of the sales that are similar to the investment property. Formulas PGIM = Value PGI EGIM = Value EGI Example: Assume a property has a value (sales price) of $400,000. Its PGI is $90,000 with a 5% vacancy factor. What is the PGIM and the EGIM? Value of the investment property $400,000 PGI $ 90,000 Less: 5% Vacancy/Collection Loss ($ 4,500) EGI $ 85,500 Deriving PGIM Deriving EGIM PGIM = Sale Price PGI EGIM = Sale Price EGI PGIM = $400,000 $90,000 EGIM = $400,000 $85,500 PGIM = 4.44 EGIM = 4.68 Limitations of Income Multiplier Techniques The main drawback in using multiplier techniques is that they are based on gross income and rent ignoring the net income that a property may generate. In many cases, investors are more interested in net than gross income. Two properties may generate very similar levels of gross income. However, one may have significantly higher net income since it has lower operating expenses. All

8 400 Real Estate Economics other things being equal, the property with the higher net income would tend to be in greater demand and more valuable. Using a multiplier technique, this difference is ignored. Factors to Consider When Using Income Multipliers Use properties that are similar to the investment and each other in terms of physical, locational, and investment characteristics. Be sure the rental data used with the sales is fair market rent. At times, properties sell with low rents because the property owner did not want to disturb the tenants, even though their cooperation was needed to show the property. This is potentially the biggest source of error in use of income multipliers. Gross income multipliers (GIMs) suggest some of the income used comes from sources other than rent. A gross rent multiplier (GRM) is used only with rental income. The types of leases in other rentals have to be similar to those analyzed in the investment property. For example, GIMs derived from gross leases cannot be compared to net leases. The investor can use either the potential gross income (PGI) or the effective gross income (EGI), but the data and measure must be used consistently throughout the analysis to produce credible results. The income measure selected is a function of market data and the purpose of the analysis. Income Capitalization Real estate investors most often purchase or develop properties with the expectation of deriving a cash flow. The more income a property generates for its owner, the more valuable the property. Income capitalization is based on the premise that there is an identifiable relationship between the net income a property generates and the value of the property. The process of estimating the present worth of a property based on its anticipated income is capitalization. Capitalization converts income to capital value. Income capitalization generally involves a three-step process: (1) estimate net operating income, (2) select an appropriate capitalization rate, and (3) capitalize the income.

9 Unit 14: Determining Value & Profitability 401 Capitalization Formulas Determine a property s value: Determine the cap rate: Calculate a property s NOI: V = NOI OAR OAR = NOI V NOI = V OAR An investor examines an income property s operating statement, analyzes the information, and reconstructs the operating statement. Capitalization Rates When an investor considers buying a property for its income-producing capabilities, he or she obviously wants the investment to be profitable. For an investor, the return on investment is the profit produced by the investment. The capitalization rate is the rate of interest which is considered a reasonable return on the investment. It answers the question, How much will I earn from making this investment? The return or profit from an investment is also known as the yield. A second factor each investor considers is Will I be able to recoup my investment when I decide it is time to sell? Another aspect of this analysis is whether the property will sell for more than the original purchase price. The recapture or conversion of the investment to cash or other valuable assets is known as the return of investment. Types of Capitalization Rates There are four basic types of rates used in the capitalization process. Interest rate is the return on an investment necessary to attract capital funds. The interest rate is the RETURN ON INVESTMENT and is the rate of interest considered to be a reasonable return on an investment. It is applicable only to the net income from the land. It is also described as the yield rate necessary to attract the money of the average investor to a particular type of investment. The recapture rate is the RETURN OF INVESTMENT and is the rate that an investor recovers invested money. It is applicable only to the net income from improvements. When buildings or other improvements contribute to the production of income, an allowance must be made for recapture of the value of the improvements. Structural improvements have a limited economic life, whereas land may generally be used indefinitely.

10 402 Real Estate Economics The overall capitalization rate (OAR), or simply the cap rate, is a marketderived ratio reflecting the relationship between the net operating income a property generates and its value. It is used to convert expected net operating income (NOI) generated by a property into a value estimate (V) for that property. It provides for both the return on investment and return of invested capital, but the proportions are unknown. Generally, an investor uses a capitalization rate in which investment value, rather than property value, is desired. Example: Find the overall capitalization rate if a property sold for $800,000 and has a NOI of $72,000. Cap Rate = NOI Sales Price Cap Rate = $72,000 $800,000 Cap Rate =.09 or 9% The type of capitalization rate selected depends on the capitalization technique used. Example: An income-producing property has a NOI of $80,000. The overall cap rate (OAR) is estimated to be 6%. What is the value of the property? Value = NOI OAR Value = $80, Value = $1,333,333 A composite capitalization rate provides both a return on the investment and a return of the investment value. It differs from an overall capitalization rate because it is derived from known proportion of both interest rate and recapture rate. Capitalization Rates and Risk Because real estate competes with all other types of investment for available investment funds, when estimating the rate of return demanded by investors, an investor must consider many characteristics of a particular investment.

11 Unit 14: Determining Value & Profitability 403 Characteristics to Consider when Evaluating an Investment Reliability of net income Probability of increase or decrease in value Taxation Liquidity Burden of management Hypothecation Leverage Just as real estate competes with other investments for capital funds, each parcel of real estate competes with every other parcel. Capitalization rates for real property vary with the type, age, and condition of the property, location, and surrounding developments, and existing economic conditions. Capitalization rates and value are inversely proportional. If there is a high-risk property, there will be a high capitalization rate and a low value. Low risk investments are those with a lower possibility of losing money, along with the possibility of less income. If the risk factor is low, the capitalization rate will be low and the value will be high. Review Cap Rates and Risk Low risk = Low OAR = High value High risk = High OAR = Low value The more secure the future net income, the lower the capitalization rate. A lower rate would be used in capitalizing the income from an apartment house in a well-maintained and stable neighborhood than in an area of declining economic conditions. The difference in capitalization rates would reflect people s judgment of the quality of the properties in relation to the characteristics of a good investment. In an undesirable neighborhood, the capitalization rate might be higher because the reliability of income is poorer, the probability of appreciation in value is less, and the burden of management is greater. It is similar to investors who purchase second and third mortgages. These are not as safe as a first mortgage but can have a higher return. If these mortgages are sold, they require a higher discount than the first mortgage. The age, condition, and construction of the buildings on improved properties have a direct effect on the capitalization rate. The resulting rate is a combination of interest rate and recapture rate. The value of improvements

12 404 Real Estate Economics must be recaptured during the remaining economic life. The shorter the future economic life of the improvements, the greater the annual allowance for recapture. The value of a building with an estimated future economic life of 50 years must be recaptured at a rate of 2% per year. The value of a building with an estimated future economic life of 20 years must be recaptured at a rate of 5% per year. Usually, the older the building, the cheaper the construction, or the poorer the condition, the shorter will be the estimated future economic life and the greater will be the annual recapture rate. Selecting Capitalization Rates Selecting the capitalization rate is one of the most important parts of the capitalization process. A minor change in the rate will cause a substantial difference in property value. A rate increase from 8% to 9% will result in an 11% decrease in value. Example: Find the percentage decrease in value of a property if $60,000 NOI is capitalized at 8% and 9%. Step 1: Value = NOI Cap Rate Value = $60, Value = $750,000 Step 2: Value = $60, Value = $666,670 Step 3: Calculate the decrease in value $750,000 - $666,670 = $83,330 Step 4: Calculate the percentage decrease in value Percentage decrease = $83,300 $750,000 Percentage decrease = 11% Methods to Derive Capitalization Rates Three methods have been developed to aid the investor in selecting a capitalization rate: (1) comparative sales method, (2) band of investment method, and (3) summation method. Comparative Sales Method If there is sufficient data, it is preferable to derive the capitalization rate from comparable sales. The investor needs to determine if the income, expenses, financing terms, and market conditions at the time of the sale of the comparable

13 Unit 14: Determining Value & Profitability 405 are appropriate to use with the investment property. This is especially true for the net operating income (NOI) as the expenses for the comparables may represent the year that just ended and may have to be adjusted to the date of value used for the investment property. Besides income and expense data, the investor also needs to consider allowances for replacement and needs to ensure these are adjusted to the current conditions as of the date of value. As we discussed earlier, it is also important for the investor to ensure that there are no special financing concessions that may affect the sales price of the comparable properties. When the investor derives the capitalization rate using comparable sales, the overall rate is applied to the property in a manner consistent with its derivation. If the capitalization rate of the comparables is based upon the NOI and expenses for the next year, then this capitalization rate should be applied to the property and its projected NOI for the next year as well. Once comparable sales have been identified and verified and appropriate adjustments have been made, the investor can determine the capitalization rate of the comparable sale by dividing its NOI by the sales price. The capitalization rate chosen by the investor from those indicated by the comparable sales would be the one indicated by the sale that is most similar to the property. At times, actual operating expense information for the comparable sales is unavailable, but the gross income and sales price information is available. As a reminder, operating expenses are expenses required to run a property (i.e., to maintain its income). In those situations, an investor must analyze the market to determine typical market operating expenses. From this market estimate, an investor can estimate operating expenses for the chosen comparable property. Then, the investor subtracts the estimated operating expenses from each comp s effective gross income to determine the property s NOI. Example: The operating statement for the property shows that its NOI is $575,000. After researching the market area, the investor came up with the following comparable information. Comparables NOI Sales Price Cap Rate Comp 1 $450,000 $5,000,000 9.% Comp 2 $357,750 $3,578, % Comp 3 $1,506,800 $25,113,000 6.% Comp 4 $600,000 $6,316, %

14 406 Real Estate Economics After further analysis, the investor concludes that Comp 3 is not especially indicative of the market, even though on the surface it appeared to be wholly comparable to the property. Looking at the remaining comps, the investor concludes that the cap rate most likely should be in between 9-9.5%. The investor ultimately selects 9.5% because Comp 4 was the most comparable to the property. $575, % = $6,052,631. The property has a value of $6,053,000 (rounded). Selection of a capitalization rate from comparative sales involves a direct analysis of transactions between buyers and sellers in the market. The capitalization rate indicated by a sale is determined by dividing the sales price into the net income from the property. A sales price of $600,000 for a property with an annual net operating income of $57,000 would indicate a cap rate of 9.5%. ($57,000 $600,000 =.095 or 9.5%) Sales of several similar properties must be analyzed in the same manner and the indicated rates must be correlated into one. This method does not take into account possible fluctuations in future cash flows, but uses data from a fixed period in time the time of sale. It assumes that expected changes in income performance will be the same for the property and comparable properties. Selection of a capitalization rate by the comparative sales method is considered the most appropriate method, since it directly reflects the capitalization rates at which properties are bought and sold. Even though the calculations used in this method are simple, its application has many hazards. The investor must use good judgment in selecting a capitalization rate. Before accepting a rate estimated by the comparative sales method, several factors must be considered. 1. The comparative sales should be recent. Capitalization rates change with general economic conditions. 2. The net income imputed to the sale properties must be derived in the same way as that of the property. lf applicable, the same type of expenses must be deducted from the gross income of the sale parcel as from the gross income of the property. Often, the same ratio of gross income to net income as was estimated for the property is used for the sale property. 3. The sale property should be located in the same neighborhood as the property or in a neighborhood considered equally desirable. 4. The improvements of the sale property should be similar to those of the investment property in type or class, age and condition, size, construction, and ratio of building to land.

15 Unit 14: Determining Value & Profitability 407 In investment practice, it is often difficult to obtain sufficient sales data to derive a capitalization rate directly applicable to the property. It may be necessary to adjust the capitalization rates indicated by the sales to the rate proper for the property. Adjustment of rates indicated by other comparable sales and correlation of these rates to select a capitalization rate for the property involves the investor s judgment. As we said before, differences in capitalization rates reflect the quality of the properties in relation to the features of a good investment. If a comparable sale property indicates a rate of 11%, any features of the comparable sale property superior to the property indicate a rate higher than 11% for the investment property. Conversely, features of the property superior to the sale property indicate a rate lower than 11% for the investment property. A capitalization rate from a comparative sale may be adjusted up or down for any number of differences. The more adjustments necessary, the less reliable the indicated capitalization rate. Capitalization rates derived from properties with structural improvements include both an interest rate and a recapture allowance. Since the recapture portion of the capitalization rate applies only to the income attributable to the improvements, you must segregate land and building values for the sale property. Estimate the remaining economic life of the building. Multiply the annual recapture rate by the building value to determine the annual recapture in dollars. Deduct this figure from the net income to determine net income after recapture. Dividing the sale price into the net income after recapture yields the interest rate. Example: Compute the interest rate by the comparative sales method using the following information. Sales price $800,000 Building value (75%) $600,000 Remaining life of building 50 years Annual net income $72,000 Step 1: Calculate the Recapture Rate Recapture rate = 100% 50 years Recapture rate =.02 or 2% Step 2: Calculate the Recapture Recapture = Building Value x Recapture Rate Recapture = $600,000 x.02 Recapture = $12,000

16 408 Real Estate Economics Step 3: Calculate the Net Income After Recapture Net income = NOI - Recapture Net income = $72,000 - $12,000 Net income = $60,000 Step 4: Calculate the Interest Rate Interest rate = Net Income Sales price of the property Interest rate = $60,000 $800,000 Interest rate = 7.5% Estimating a capitalization rate by the comparative sales method is the most practical method. In practice, an investor keeps abreast of current capitalization rates by a continual analysis of property sales and listings and by discussions with informed buyers and sellers. Deriving Capitalization Rates from Operating Data An investor can derive a cap rate by using operating statement ratios operating expense ratio and net income ratio. The operating expense ratio (OER) is the relationship of a property s expenses to income, which is found by dividing total operating expenses by effective gross income (EGI). The net income ratio (NIR) is the ratio between the net operating income of a property and its effective gross income. It is calculated by dividing the net operating income (NOI) by the effective gross income (EGI). Example: Calculate the net income ratio (NIR) for a property with an effective gross income (EGI) of $80,000 and operating expenses (from market data) of $45,000. Step 1: Calculate the Net Operating Income (NOI) NOI = EGI - Operating Expenses NOI = $80,000 - $45,000 NOI = $35,000 Step 2: Calculate the Net Income Ratio (NIR) NIR = NOI EGI NIR = $35,000 $80,000 NIR = or 44% Because the operating expense and net income ratios are complementary, adding them together will result in 1.0 or 100%. This relationship is useful when an investor is able to calculate one but needs the other. To do this, subtract the known ratio from 1.0 or 100%

17 Unit 14: Determining Value & Profitability 409 Example: A property has an effective gross income of $78,000 and operating expenses totaling $31,200. The NOI is $46,800 ($78,000 $31,200). The following chart shows how the operating expense ratio and net operating income ratio are inverses of one another. Net income ratio $46,800 $78,000 = 60% (0.6) Operating expense ratio $31,200 $78,000 = 40% (0.4) 100% (1.0) Band of Investment Band of investment is a method of estimating interest and capitalization rates, based on a weighted average of the mortgage interest rate (or other cost of borrowed funds) and the rate of return on equity required. When a property is purchased, it is normally financed with a combination of equity from the purchaser and a loan from some bank or investor. Lenders anticipate receiving a competitive interest rate associated with the creditworthiness of the borrower and the perceived risk of the investment. The lender normally wants both returns on the investment as well as a return of investment, so the typical loan is amortized. In a similar manner, equity investors want a competitive equity cash return at an appropriate rate, or they will seek investments elsewhere. The band of investment is a technique in which the capitalization rates demanded by the lender as well as the investor are weighted and presented as a percentage, which represents a capitalization rate. This procedure uses a weighted-average rate attributable to the total investment. Using this technique, the investor determines a capitalization rate for both the equity and the debt position for a property and then combines these two rates into an overall rate. Example: Assume a property is purchased for $900,000. The loan to value ratio is 70%, which is typical for this kind of investment. The following ratio between equity and loan applies: Equity Value (30%) = $270,000 Mortgage Value (70%) = $630,000 Property Value (100%) = $900,000 The band of investment derives a capitalization rate by combining the mortgage constant (capitalization rate) with the investor capitalization rate. The mortgage constant or mortgage capitalization rate (R M ) is the ratio of annual debt service to the principal amount of the mortgage loan. The mortgage constant is affected by the loan interest rate, the term of the loan, and the

18 410 Real Estate Economics frequency of the payments of interest and principal. Mortgage constants can be calculated on a financial calculator or by referring to financial tables. Formula Mortgage Constant R M = Debt Service Mortgage Principal The capitalization rate for the equity is referred to as the equity capitalization rate (R E ). The equity capitalization rate is the factor used to estimate the value of the equity in the band of investment method of capitalization and other mortgage and equity techniques. There are different ways to calculate this depending upon the nature and size of the investment. R E is used to convert an equity dividend into an equity value indication. Formula Equity Capitalization Rate R E = Equity Dividend Equity Invested The formula above reflects one way to calculate the equity capitalization rate, which is to divide the pretax cash flow by the equity investment into the property. If it can be obtained, it is a very strong indication of the capitalization rate assigned to the equity. Investors often determine R E by comparing the interest rates being paid on other investments to the return expected for the investment property. For a safe conservative investment, the investor may use rates from treasury bills or other similar investments. For riskier investments, the investor may use the rates being paid on subprime loans or the interest rates for second and third mortgages. As previously indicated, the cap rate from the band of investment must satisfy both the mortgage component and the equity dividend requirement of the investor. For mortgage-equity analysis, the cap rate can be thought of as a composite rate. Thus, the cap rate is a weighted average of the mortgage capitalization rate and the equity capitalization rate. This relationship is shown below. Percent of Property Value Cap Rate = Weighted Component Mortgage (%) R M = From Mortgage Equity (%) R E = From Equity

19 Unit 14: Determining Value & Profitability 411 Example: The investment property is a 10-unit apartment building. The investor is putting 30% down and securing a loan for the remaining 70%. The interest rate for the mortgage is 6.5%. The loan term is 25 years. This is an average risk purchase so the investor wants to see a return of at least 8% as this is more than the current rate for T-Bills and other secure investments. Using the formula presented above, compute the cap rate. Percent of Property Value x Cap Rate = Weighted Component Mortgage: 70% x * = Equity: 30% x 0.08 = Overall Cap Rate = or 8% rounded * This represents the mortgage constant for an amortized loan at 6.5% with a 25 year term. Summation Method Estimating a capitalization rate by the summation method requires considerable subjective judgment on the part of the investor. For this reason, it is best to use this method only as a check against one of the other available methods. The summation method establishes a safe rate for an investment and adds or subtracts from this basic rate according to the proper interest rate for the investment property. The safe rate chosen is usually that of a risk-free investment, such as savings deposits or government bonds. Additions or subtractions are made by percentages for investment characteristics considered more or less desirable than the safe-rate investment. Review Considerations When Evaluating an Investment 1. Reliability of net income 2. Liquidity 3. Burden of management 4. Probability of increase or decrease in value 5. Taxation 6. Hypothecation 7. Leverage The relative importance of any particular characteristic depends on the type of investment being evaluated. Although other investment characteristics might be added to the list, enlarging it would result in overlapping of elements or including items of minor importance. For instance, risk is a major consideration in an investment. However, risk is considered with both the reliability of net income and the probability of increase or decrease in value. The investor prepares a chart showing how the potential investment differs from the safe rate investment.

20 412 Real Estate Economics Safe rate 8.0% Adjustments Reliability of net income + 2.0% Liquidity + 1.5% Burden of management + 1.0% Probability of appreciation 4.0% Indicated interest rate 8.5% The rate derived by the summation method is an interest rate. Any allowance necessary for the recapture of improvement cost must be added to this rate. Direct Capitalization A widely used method for converting income into an estimate of value is direct capitalization. Direct capitalization converts an estimate of a single year s income into an indication of value. Direct capitalization is most often used when properties are already operating with a stabilized income and expense basis and there is sufficient sales data for properties that are similar to the investment. These properties should have similar risk levels, incomes, expenses, physical and locational characteristics, and the expectation that future income levels will be similar to the investment property. This method is less useful for properties during initial lease-up or for properties with varying income and expense levels in the future. The advantage of direct capitalization is that it is simple to use, easy to explain, provides strong market evidence of value, and expresses what the participants in the market are thinking. Using the direct capitalization method, an investor who will pay $1 million for a property yielding an annual net operating income (NOI) of $90,000 is indicating a willingness to purchase the property at a 9% capitalization rate. If other investors are willing to transfer similar property on the same terms, the capitalization rate indicated for this particular type of property is 9%. Applying this data to the capitalization process, an annual net operating income (NOI) of $90,000 divided by the capitalization rate of 9% indicates a property value of $1 million. Property Value = NOI Cap Rate Property Value = $90, Property Value = $1,000,000 In practice, it is very difficult to obtain true NOI from investors of similar properties.

21 Unit 14: Determining Value & Profitability 413 PROFITABILITY MEASURES Real estate investors want to know whether the investment will generate a profit or positive return on investment. There are different ways to measure the performance of an investment property, such as the breakeven analysis, payback period, cash on cash return, return on investment, net present value, and internal rate of return. Break-even Point Analysis The break-even point analysis has been commonly used in business and industry for many years. Essentially, the breakeven point (BEP) is the point at which gains equal losses; or, in real estate, it is the point at which effective gross income equals expenses. A real estate investment should generate an income stream that is sufficient to cover costs and expenses. This information allows an investor to know the level where he or she will not experience a profit or a loss on the capital invested. There are different variations of a break-even analysis calculation, but a simple method is to examine the relationship between the income and the expenses associated with the property. The expenses include all fixed and variable expenses involved in maintaining the property. Lenders calculate the break-even ratio as one of their analysis methods when considering providing financing for a real estate investment property. Too high of a break-even ratio is a cautionary indicator. Example: Assume the annual gross operating income from a property is $52,000, direct operating costs and management are $27,640, and annual debt service is $15,000. The break-even ratio for this property is 82%. [$15,000 + $27,460 / $52,000 =.82 or an 82%] The variable ratio can be expressed as a percent per rental dollar collected as income. The variable expense ratio is a ratio of the variable expenses as a percentage of the rental income.

22 414 Real Estate Economics Payback Period BEP = Fixed Expenses (1 Variable Expense Ratio) Example: Calculate the BEP for an investment property that has $75,000 fixed expenses and a variable expense ratio of 25%. BEP = Fixed expenses (1 Variable expense ratio) BEP = $75,000 (1 0.25) BEP = $75, BEP = $100,000 In order to break even on the investment, the property must be able to generate at least $100,000 of income to reach the break-even point. Another method of analyzing investments is the investment s payback period or the payback period index. The payback period is the time it takes to recover an investment. The analyst usually uses this tool along with others and then only in comparison with an analysis of the payback periods of other investments. The total amount invested is divided by the annual expected cash flow to arrive at the number of years required to recover the original investment. PB = equity capial outlay annual net equity cash flows Investors (real estate or otherwise) use this tool to tell them how fast they will get their seed money back (remember that real estate is illiquid, so this can be an important part of the purchase/not purchase decision). Obviously, a shorter payback period beats a longer one. Example: Assume that the initial investment of $100,000 remains unchanged and the annual income remains more or less constant at $10,000 over the life of the investment. The income from the property gradually builds over time until the total income received equals and then exceeds the initial investment amount. The payback period for this investment is 10 years.

23 Unit 14: Determining Value & Profitability 415 Cash on Cash Return Rather than paying all cash for an investment, a real estate investor will usually take advantage of leverage in order to purchase the property. Leverage is the use of borrowed capital to finance a transaction. Most real estate investors will use leverage, which allows them to provide only a small amount of their own capital as a down payment and to borrow the rest necessary to purchase the investment property. Cash on cash return (CoCR) is the ratio of the return on the initial amount of invested capital provided. The CoCR, expressed as a percentage, uses the amount of cash flow of an investment property before taxes. Formula Cash on Cash Return CoCR = Cash Flow before Taxes Initial Capital Invested Example: A real estate investor wants to know what the cash on cash return is for a potential investment if he uses $50,000 of his own capital and finances the rest of the purchase price. The amount of cash flow generated from the property before taxes is equal to $2,000. Return On Investment CoCR = Cash Flow before Taxes Initial Capital Invested CoCR = $2,000 $50,000 CoCR = 4% As discussed earlier in this unit, the return on investment (ROI) is the profit produced by the investment. The ROI compares what the investor has put into the property and what that same investor has gotten out of it. The ROI tries to provide a big picture analysis of the property s profitability. For investors, the ROI describes how well or poorly they are investing their money.

24 416 Real Estate Economics The ROI can be used on both rental properties and speculative investments. Moreover, it can be used to compare all types of potential investments, not just real estate. The smart investor uses it to compare a stock purchase against a real estate investment. Would the investor be better off putting a $20,000 bonus in the company s stock plan or in the purchase of a ranch? For income-producing properties, the ROI is the net earnings divided by the capital investments made by the investor. The capital investment in the ROI calculation is not the purchase price. The capital investment, instead, concerns the down payment, any portion of the purchase price or closing costs paid out of pocket by the investor, and additional cash spent by the investor for other capital improvements. Example: David is considering the purchase of a new $400,000 fourplex and will live in one of the units. He plans to make a down payment of $80,000 and anticipates about $10,000 in closing costs, for a total investment of $90,000. The debt service on the purchase will be approximately $24,500 per year. David expects the three tenant-occupied units to generate a net operating income of $28,000 and a cash flow of $3,500 in the first year. However, David is planning to sell it in one year for an additional net profit of $14,500. As a total investment, this project s ROI is calculated 20%. Calculating ROI (Annualized Calculation) Net operating income $28,000 Less: Debt servicing (loan) 24,500 Cash flow from operations 3,500 Plus: Sale of Property 14,500 Total projected returns $18,000 Total capital investment $90,000 Projected ROI 20.0% A 20% ROI is a very good prospect, particularly for a one-year investment. Compare that to a bank Certificate of Deposit (CD) or an S&P-based mutual fund. Unfortunately, not all real estate investments are profitable ventures. A decrepit property may require lots of additional capital improvements and outlays from the investor. The unprepared investor may be lucky to get out of the investment with a small loss. In such a case, a very safe low-yield CD begins to look very attractive indeed.

25 Unit 14: Determining Value & Profitability 417 NPV and IRR Two tools suited for measuring investment performance are net present value (NPV) and internal rate of return (IRR). Both are based on the same principles of discounted cash flow analysis. Discounted cash flow analysis is a method in which the value of future benefits is discounted to a present value. Future benefits include the periodic flow of income generated by a property for its owner (RETURN ON INVESTMENT) as well as a reversion. Reversion is the lump sum amount the investor expects to receive upon sale of a property at some future point in time (RETURN OF INVESTMENT). The process in which the periodic future income flows and the reversion are converted into a present value estimate is called discounting. The NPV is expressed in monetary units and the IRR is expressed as a percentage. NPV shows the value of future cash flows discounted back to the present by a percentage that represents the minimum desired rate of return. The IRR calculates a break-even rate of return. It shows the discount rate below which an investment results in a positive NPV and above which an investment results in a negative NPV. The IRR can be thought of as a breakeven discount rate, the rate at which the value of cash outflows equals the value of the cash inflows. These are sophisticated concepts, and we will cover them only lightly here because of the math involved. Both of these have a component called present value. What this means is that they take cash flows in the future and then discount them to present value. For example, the present value of $100 (as a lump sum) five years into the future discounted at 5% is $ Therefore, when we refer to a discounted value, we mean the value today of a lump sum of money in the future. Of course, discount (yield) rates will vary. Both NPV and IRR are best used to calculate the performance of an investment property after it has been purchased, held, managed, and then sold. However, an investor can make some assumptions and have target yields, but these would be nothing more than possible outcomes, not true analyses of the investment s yield. Net Present Value (NPV) In the net present value (NPV) approach to investment analysis, the total expected returns from an investment are discounted in a manner to arrive at the worth of those returns in terms of present dollars. The total expected returns include the present values of an investment s cash flows including

26 418 Real Estate Economics the initial investment, its net cash flows over the holding period, and the projected profit at sale. The sum of the returns expressed in current dollars after deducting the total investment requirement could be negative, equal to zero, or be positive. The key here is the discount rate you chose. If the total of the discounted cash flows you use is negative, you have not achieved the discount rate, i.e., the yield, you chose. If it is zero, then your target discount rate and the discount rate you chose are the same. If the total is positive, then your actual yield is higher than the discount rate you chose. Example: Assume a commercial building is listed to sell for $250,000. It is leased to a single tenant on a net lease for $12,000 annually for 10 years and the lessee has an option at the end of 10 years to purchase the property for $300,000. The total return for the property over the 10-year period is $420,000 [$120,000 ($12,000 for 10 years) plus $300,000 sale in the 10 th year]. The investor would not pay $420,000 and the seller is asking $250,000, but how much is it worth? When evaluating this property, there are three basic steps to determine what an investor should pay for this property. Currently, investors are requiring at least a 6% return for this type of investment. First, determine the present value of the $12,000 income for 10 years, in today s dollars. This can be calculated using a financial calculator or obtaining a factor from financial tables. The factor used is $12,000 x = $88, The second step is to determine the present worth of the $300,000 paid by the tenant at the end of the 10 th year of the lease. This also can be calculated using a financial calculator or obtaining a factor from financial tables. The factor used is $300,000 x = $167, The last step is to add the present worth of the total returns and subtract the total investment requirement to arrive at a net value. The present worth of the total returns is $255, If the difference is zero, then the project equals