# Tag: real estate investing

## Estimating the Value of a Real Estate Investment Using Cap Rate

Why do you invest in income-producing real estate? Perhaps you are looking for cash flow. Possibly you anticipate some tax benefits. Almost certainly, you expect to realize a capital gain, selling the property at some future time for a profit.

Your projection of the future worth of the property, therefore, can be a vital element in your investment decision.

#### APPRECIATION

A fairly simple approach to this issue is the use of an appreciation rate. You bought the property today for X dollars. You make a conservative estimate as to the rate of appreciation, apply that rate to your original cost and improvements and come up with presumed future value.

The use of appreciation as a predictor of future value typically makes sense when the desirability of the subject property is based on something other than its rental income. The most common example, of course, is the single-family residence. Consider also a single-user rental property such as a small retail building on a main thoroughfare. The owner of a business operating as a tenant in such a location is probably willing to spend more for the building than an investor would pay. In general, rate of appreciation as a predictor of future value may be appropriate when comparable sales work well as a measure of present value (i.e., “Commercial buildings on Main Street are selling for \$200 per square foot by next year they will be up to \$225.”).

#### INCOME CAPITALIZATION

With most other types of income-producing real estate, what you paid for the property is not likely to make much of an impression on a new buyer. Witness the rapid run-up and even faster collapse of prices in the late ‘80s, and again in 2008. The typical investor will be interested in the income that the property can generate now and into the future. He or she is not buying a building, but rather its income stream.

That investor is likely to use capitalization of income as one method of estimating value. You have probably heard this referred to as a “Cap Rate” method. It assumes that an investment property’s value bears a direct relation to the property’s ability to throw off net income.

Mathematically, a property’s simple capitalization rate is the ratio between its net operating income (NOI) and its present value:

#### Cap. Rate = NOI/Present Value

Net operating income is the gross scheduled income less vacancy and credit loss and less operating expenses. Mortgage payments and depreciation are not considered operating expenses, so the NOI is essentially the net income that you might realize if you bought the property for all cash. If you purchase a property for \$100,000 and have a NOI of \$10,000, then your simple capitalization rate is 10%.

To use capitalization to predict value requires just a transposition of the formula:

#### Present Value = NOI/Cap. Rate

The projected value in any given year is equal to the expected NOI divided by the investor’s required capitalization rate.

To use capitalization rate as a predictor of future value, in short, is to use this logic: “I am buying this property with the expectation that its net operating income will represent a return on my investment. It is reasonable to assume that whoever buys the property from me in the future will have a similar expectation. That new investor will probably be willing to purchase the property at a price that allows it to yield his or her desired rate of return (i.e., capitalization rate).”

If you project that the property will yield a NOI of \$27,000, and that a new buyer will require a 9% rate of return (capitalization rate), then you will estimate a resale price of \$300,000.

You must never forget that, while the algebra involved here is simple, the judgments you need to make in order to achieve an accurate prediction of value are more complex. Your assumptions as to future years’ income and expenses have to be realistic.

The same is true of your estimate of a new buyer’s required cap rate. Look at the investment from the new buyer’s point of view and remember that there are other opportunities competing for his dollar. Would you buy an office building with a projected cap rate of 9% if you could buy a bond that yields 7%? What if mutual funds are rocking and rolling at 15% and more? To attract a buyer, your property may need to be priced so that its cap rate is competitive with alternative investment options. The higher the cap rate, the lower the price. In our example above, the property with the \$27,000 NOI capitalized at 12% might attract an offer of \$225,000.

Our discussion here has been limited to simple or “market” capitalization rates. If you would like to delve further into this topic you may want to look into “band of investment” or derived cap rates. In addition, follow our blog as we go into greater depth as to how investors look at a property’s projected long-term income stream when deciding if and on what terms to purchase an income property.

—Frank Gallinelli

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Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Learn more at www.realdata.com.

## Rate of Return on No Money Down (and Other Tales from the Deep Woods)

We frequently hear a question that goes something like this: “I’m considering the purchase of an income property where the seller will take back a second mortgage for the entire down payment. Why can’t your software figure out the rate of return on a zero-cash-down investment?”

You’ve surely heard the excuse, “It’s not the software’s fault” more times than you care to recall. This time, however, the blame really does not fall upon the software, the hardware, the astronauts, Bill Gates, el niño or any of the other usual suspects.

The problem lies in the question itself: “What is the rate of return on a zero-cash-down investment?” Let’s try posing this query a few other ways:

“What’s my return on investment when I make no investment?”

“What’s my rate of return on nothing down?”

“What’s my rate of return on nothing?”

You can see where we’re going with this. You cannot calculate the return because there is no such thing as a zero-cash-down investment. If you invest nothing, then you have no investment. You might just as well ask, “What is the height of an adult unicorn?” because you would get the same answer. No such animal.

This is not just clever semantic swordplay. Fundamental to the concept of investment is that you put your own capital at risk. (For the alert reader, capital could take a form other than cash. I once witnessed a deal where the buyer signed over a sports car as his down payment. For the sake of simplicity, we’ll just refer to the buyer’s investment as cash, with or without wire wheels.)

No-money-down violates the letter, the spirit and the algebra of conventional investment. Return on investment, by its simplest definition, is the amount of the return divided by the amount of the investment. Anything divided by zero is infinity. Hence, even a one-cent return on a zero-dollar investment would be an infinite rate of return.

In short, if you as the buyer put no cash into the deal, you have made no investment and hence you cannot calculate a rate of return. Even if the acquisition of an income property with no outlay of cash should not be called an investment, such deals do happen and can even succeed (although perhaps not as effortlessly as in the mountain of books and tapes showing how you too can amass great wealth with no cash).

If you cannot measure the potential success of a no-money-down deal using rate of return, is it time to put away your computer, trust your instincts and not bother with any kind of financial analysis? Quite the contrary. Even if you can’t measure the rate of return, you can still perform some essential analysis. In fact, caution may demand that a “non-investment” such as this, with little margin for error, be scrutinized with even greater than usual care.

In particular, there are two important issues that require careful examination: Cash flow and resale. If you are going to try to finance 100% of a property’s purchase price, you are obviously going to have to service more debt than you would if you had put some meaningful amount down. Can the property’s income cover all of its operating expenses as well as these debt payments? If not, then you’ll have to reach into your own pocket to make up the difference (so much for the “no cash, no problem” scenario).

Here is where you have to take a very hard look at the numbers. The burden of debt payments on a property with 100% financing leaves you very little wiggle room. Are the income figures realistic? Are you relying on immediate rent increases to cover your costs, increases that could initially result in vacancies rather than additional revenue? Are your expense projections based on verifiable sources and do you have the resources to handle unwelcome surprises?

A second key issue is the property’s potential resale value. (If you haven’t done so already, you should read our previous articles on “Understanding Net Operating Income,” and “Understanding Real Estate Resale.” and even take our e-course or read my books to help you understand the relationship between income and value.) Since your financing is likely to eat up most of your cash flow, the eventual resale of the property is where you will typically have the greatest chance of making money. Once again, realism is of paramount importance. Why might a new buyer give you more than you paid? Can you make physical improvements and management improvements that will make this property attractive and more valuable to an investor?

To recycle an old saying, if no-money-down deals were easy, everyone would do them. Even though you can’t calculate a conventional rate-of-return, be sure that you do the rest of your homework — cash flow projections and estimated resale — before you take the plunge.

The math surrounding vacancy and credit loss allowance is certainly simple enough. You start with your top line – Gross Scheduled Income – which represents a perfect-world situation where all units in your property are rented and all your tenants pay on time with good checks. From that you subtract an allowance to account for the warts of an imperfect world, in this case the potential rent that may be lost to vacancy and the revenue lost due to the failure of tenants to pay. Typically you will estimate the allowance as a percentage of the Gross Scheduled Income.

The result is called the Gross Operating Income (also known as Effective Gross Income). From that subtract the property’s operating expenses and the result is the Net Operating Income, the number you will capitalize in order to estimate the property’s value. An example should make this easy to see:

In this example you’ve assumed that about 3% of your potential income will be lost to vacancy and credit. As you examine this table, you’ll recognize that the greater the vacancy and credit loss, the lower the NOI and hence the lower the value of the property. There’s a lesson here, of course. The vacancy and credit loss projections you make, for the current year and for the future, are going to have a direct impact on your estimate of the property’s value. If you’re careless about these projections you risk skewing that estimate of value.

#### Vacancy Loss

Behind the numbers are some truisms that you want to keep in mind. The first, of course, is that vacancy and credit loss are generally unwelcome. Loss is loss. However, experienced investors will usually not fall on their swords at the first sign of an empty unit. Conventional wisdom among veterans is, “If you never experience a vacancy, your rents are too low.” I’ve never seen anyone break out the champagne upon learning of a vacancy, but there is some merit in this seemingly self-delusional chestnut. One certain way to find the top of the market is to push past it. When you reach a rate where you no longer can find tenants in a reasonable amount of time, you can pull back. The vacancy you experience will cost you something, but you’ll be sustained by your expectation that the loss will be offset by the higher revenue you can earn by maximizing your rent.

Another reality to keep in mind is that not all vacancy allowances are created equal. In general, commercial space takes longer to rent than does residential and larger spaces take longer to rent than smaller. If you have a large retail space whose lease is coming up for renewal, it might not be unreasonable to allot six months or more of rent as a potential vacancy loss. At the other extreme, a properly priced studio apartment should rent quickly in most markets, so a minimal allowance would suffice.

When making projections about future vacancy, start by looking backward. How quickly has new space been absorbed in the past? Then look forward and consider what might change. What is the likelihood of new, competing space being built? Are there reasons to expect demand to rise or fall – reasons such as new employers moving in or established businesses moving out?

Remember that your objective is to forecast as accurately as possible how this property will perform for you in the future. You can and should look at best-case, worst-case and most-likely scenarios for vacancy just as you would for income and expenses, and don’t try to convince yourself that only the best case is real.

#### Credit Loss

Avoiding credit loss is a problem you get one shot at solving, and that shot occurs before you sign the lease. Would you sell me your used car in exchange for an I.O.U. or a personal check? You would expect cash or a bank draft. Why would you turn over an even more valuable asset, your rental property, without similar caution? That caution, at minimum, takes the form of a credit check and some good faith money up front in the form of security deposit and advance rent.

There are numerous companies online with whom you can establish an account for checking an applicant’s credit history. Any reputable source of credit reports will expect you to provide proof of your identity and to present written authorization from the prospective tenant to obtain the report. The simplest way to accomplish the latter is to include that authorization as part of the signed rental application. A landlord association often can help you gain access to a reliable source of credit reporting.

Credit losses are a part of doing business and you’re not likely to succeed in eliminating them completely. Your best single defense against is to establish minimum acceptable credit standards and then resist the temptation to trust your instincts and make exceptions. Everyone has a dog-ate-my-homework explanation for poor credit history. Some of the stories are probably true. Nonetheless, the single best predictor of a collection problem is past history. If he didn’t pay his cell phone bill, he probably won’t pay you either.

Some investor’s simply ignore vacancy and credit loss when making their cash flow projections. You might want to call that the emperor’s-new-clothes approach, where you see what you want to see and pretend you don’t notice what’s missing. That’s not much of an investment strategy and it won’t work for very long – reality has a habit of happening whether you plan for it or not. The more prudent investor will do his or her best to minimize these losses, but at the same time work with projections that are realistic.

## Understanding Real Estate Resale

One topic that often gets less attention than it deserves from real estate investors, however, is resale. Some tend be dismissive, looking at resale as speculation, but many others simply find it difficult to focus seriously on the matter of selling a property they haven’t yet purchased.

It may take a little extra discipline to work a consideration of resale into your investment mindset, but it is just such discipline that often separates the successful investor from the sorry.

You care about the potential cash flow, the financing, the operating costs and the tax benefits. You had better care also about whether the property will be saleable after you buy it. Often one hears, “Yes, but I plan to keep it for 15 years, or until my toddlers graduate from med school, or until the Federal Reserve Board dances figure-eights on ice with the devil.”

That’s fine; may all your plans go without a hitch. But what if you need to sell this property next year? What if a better opportunity comes along in five years, and you want to cash out? Recite this mantra whenever you consider purchasing an income property: If it’s not worth selling, then it’s not worth buying.

The world may not be perfect, but at least it’s flat – flat, as in “level playing field.” You can reasonably assume that if you would scrutinize a property’s income, operating expenses, financing and various measures of return before you purchase, then tomorrow some equally astute investor will apply a similarly jaundiced eye to your numbers if you choose to sell. It pays, therefore, to run tomorrow’s numbers today, and to see just what this investment will look like to a future buyer.

So, what are the numbers that should concern you when you analyze the potential resale of an income property? The most obvious, and the most important, is the selling price. If you have followed some of our other articles, you know that with most income properties, you can estimate the value by applying a reasonable capitalization rate to the net operating income. (If you have not read the articles, you will get probably get more out of this discussion if you go back and read them first. Their links are Understanding Net Operating Income and How to Estimate Resale Value – Using “Cap” Rates.)

In brief, you first determine the property’s Net Operating Income (NOI). Next you must estimate the capitalization rate (i.e., the rate of return) that the buyer would reasonably expect. The NOI is the amount of the return and the cap rate is the rate of return. Hence, if the market expects a 10% return and your property produces a NOI of \$12,000, your estimate of its selling price would be \$120,000. Another way of articulating the algebra involved is to say, “\$12,000 represents 10% of what?”

A curious phenomenon exists in the real world. Buyers and sellers can look at the same information and see different meanings. This, I suspect, is the closest that commercial real estate will ever come to poetry. Not only might you have a different notion of “reasonable rate of return” as a seller, you might also change your perspective on NOI. It is common for a buyer to estimate value by capitalizing the current year’s NOI, and for a seller to capitalize next year’s expected NOI. The buyer typically takes the position, “I am buying the income stream that just happened, and the property’s value is based on that income stream. If the income goes up next year, that’s my business.” The seller, as a rule, will assert, “You didn’t own the building last year. You’re buying next year’s higher income stream. The value of what you’re buying should be based on that.”

You decide.

Once you develop your estimate of the resale price, the rest of the analysis of resale is fairly straightforward. You will need to calculate the estimated tax liability at the time of sale. Then, with that number in hand you can project the sales proceeds and the overall rate of return for the holding period.

If you use RealData®’s Real Estate Investment Analysis software, you will have all of these calculations done for you. Equally important, the program will test a potential resale each year, allowing you to identify an optimum holding period. Let’s look at just the first four years of such an analysis.

Our first task is to figure the gain. We do this by taking the selling price and subtracting from it the property’s Adjusted Basis.

What is the Adjusted Basis? It is the property’s original cost, plus capital improvements, plus closing costs and costs of sale, less accumulated depreciation. Essentially the Adjusted Basis is what you spent to purchase, improve and sell the property, less the amount you have already written off. If you sell the property for more than this amount, you have a taxable gain.

In calculating your tax liability at the time of sale, there are certain deductions that may come into play. For example, you may have had operating losses in prior years that you were not allowed to take because they exceeded your “passive loss allowance.” If you could not deduct them earlier, you can deduct them at the time of sale. You may also have had loan points and leasing commissions that you were amortizing (i.e., deducting over time). If you have an unamortized balance on these items, you can deduct it when you sell.

Now you have enough information to compute the tax liability due on sale.

No doubt your greatest concern is the amount of cash you will realize from the sale. To determine that figure you must take the selling price, subtract the costs of sale (such as legal fees and sales commissions), subtract the outstanding balances of all mortgages and add back any unused funds left over in your reserve account. Now you have your Before-Tax Sale Proceeds. Subtract the Federal tax liability and you have the After-Tax Sale Proceeds.

The timing as well as the amount of your resale are important to your overall return. In this example, the software is computing that overall return for different holding periods and you can see that the timing can make a substantial difference.

Internal Rate of Return (IRR) is one of the most commonly used methods of measuring the quality of a real estate investment. Others include Present Value, Return on Equity, Cash-on-Cash Return and Debt Coverage Ratio. Some of these measures are fairly sophisticated, while others are quite simple. Check the “articles” section of our blog for more about these topics.