Investment Property Worth?
The Want Factors Don’t Work Here
Many real estate investors begin with purchasing residential real estate. Often this is because they have purchased a home or two and are somewhat familiar with the property-type and process. However, the factors used when you purchase a home to live in are very different than ones used by investors. With a home purchase it involves mainly what we here call the “want factors”. That is - you like it – you want it. There are little or no real business reasons for the purchase. The “want” factors are virtually impossible to quantify – primarily because they are based on a set of individual and very arbitrary criteria.
“Want factors” can be very dangerous when investing in real estate. What you “want” may not be the same as the next buyer and these factors have no basis in business. Part of any real estate investment is the appreciation when the property is sold – so the next buyer is an important consideration.
Commercial vs. Residential
The basic fundamentals of investing in residential real estate are no different from those of the commercial real estate world. Seasoned investors look for generic marketable characteristics and objective, quantifiable mathematical proformas to guide their decisions. However, there are two major differences between the two types. One – many of the disclosure regulations do not apply to commercial investments, which does include residential properties of greater than 4 units. The second – the dollar amounts tend to be much higher. A residential rental can cost as little as $25,000 in Florida, but developed commercial properties are rarely below $500,000 and more often than not exceed $1 million.
Location is always the single largest factor regarding the investment. Generally, you can change everything else except where a property is located. A residential property located close to shopping and schools will most likely be more rentable than one further away or backing up to an Interstate. A small retail shopping plaza with a high traffic count near a major mall will generally be worth more.
Next is utility as a rental. For homes it would be the bedroom count, bathroom count, general layout, flow and square footage. While these can be altered somewhat, it tends to be too expensive to do. For a commercial property it may be the number of suites or the ease of ingress and egress and the amount of parking available.
A third characteristic that will impact value is the overall condition of the property. Is it up to code? Are there any zoning or association issues? Will it need extensive repairs and replacements?
Sometimes whether or not the property already has a tenant or is fully leased will impact the value. Some investors prefer to re-tenant the property – others want to have the property already leased-up. One thing an occupied property can give an investor that one unoccupied cannot readily, is an idea of how much rent can be obtained. Generally, with an already leased property – the question of rental income amount is answered.
You will need to run a Cash Flow Analysis (see our Article on the subject). It should be done for one year and three or five years and whatever the life of the investment will be. It should include the “start up” costs. These are the costs of repair and replacement to get the property ready for rental. Include the hidden costs of carry and interest while this is being done as well as the direct cost of obtaining a tenant. Some investors add the unrecoverable start up costs to their cost basis to determine their return on investment (ROI).
Dollar Valuation Using IRV and the Capitalization Rate
The Cash Flow Analysis discussed above will produce the property’s estimated Net Operating Income (NOI).
Valuating the property to your particular parameters is rather simple. You will use a formula commonly referred to as “IRV”. With IRV, I = income, R = Rate and V = valuation. The standard IRV means Income equals the rate multiplied times the valuation. Here, we will be using the algebraically derived V = I / R.
Is The Juice Worth The Squeeze?
As with any formula with three variables – you need two known variables to determine the third. Here the only other thing you will need to do is determine what rate of return you require. And, an answer of “as much as possible” doesn’t work! It really means, what rate of return is required for it to be worth the risk to you? Each investor has his or her own tolerance for risk and his or her own requirements. Riskier investments tend to bring higher returns but greater chances for loss.
Once you’ve determined your return requirements – simply divide your NOI figure by that rate and you have the valuation – for you. For example: The NOI is $7800 per year – NOIs are always expressed as annual – and the rate of return we want is 8% - again annualized. The valuation = 7800 / .08 = $97,500. With these parameters - $97,500 is the maximum this investor should pay.
IRV Can Answer Other Questions
This formula can be used in a variety of ways. If the NOI and the asking price are known – then one can calculate the rate of return if purchased at that asking price. This return percentage is also known as the Capitalization Rate or “Cap Rate”. The higher the Cap Rate – the higher the return. For example: The asking price is $100,000 and the NOI is $5000. The Cap Rate here is $5000 / $100,000 or 5.00%. It would commonly be referred to as a “5 Cap”. The investor from the example in the previous paragraph would only pay $62,500 for this property since an 8% return is the requirement – that is this investor wants properties “at an 8 cap” or presumably higher.
Do Your Own Research
Be careful when obtaining the income and expense figures from listings. Many listings will state the property’s income and then give a Cap Rate. Many times that income figure is the Potential Gross Income – as an investor you want to use the Effective Gross Income for your Cap Rate and valuation calculations.
It is best to obtain or verify the income and expense data along with any other important information independently.
In addition – as touched upon above - while not necessarily standard, we suggest that you might want to include your closing costs as part of the cost of the investment. For example: a property purchased for $100,000 which as $3,500 in closing costs to you as the buyer – the number used for the “value” should be $103,500 and be used to calculate a truer ROI.
The Cap Rate and Sellers vs Buyers
Mathematically, Sellers like low cap rates and Buyers like high cap rates. The Cap Rate has a direct effect on the valuation and the lower the cap rate – the higher the valuation for a fixed income number. For example: the NOI is $10,000. The Asking Price is $125,000. This is an 8 Cap --- 10,000 / 125,000 . But if the price is negotiated to $100,000 it becomes a 10 Cap --- 10,000/ 100,000 .
The Gross Rent Multiplier and
Gross Income Multiplier
These two methods are closely related and are generally used for smaller residential properties and/or in conjunction with IRV. They tend to be used with smaller properties because to derive the data the market in which they are located must be generally active – for which smaller properties is more likely. Larger properties are fewer and tend not to turn over as much and there may not be enough data to support conclusions if there isn’t an active leasing, buying and selling market.
What is The Gross Rent Multiplier?
The Gross Rent Multiplier (GRM) refers to the ratio between a property’s gross monthly rental income and the sale price of the property. The Gross Rent Multiplier factors only the monthly gross rent and not any other form of income a property may produce. The Gross Income Multiplier uses all income sources and is annualized.
Both calculations use the same three basic steps.
Let’s look at the GRM calculation as the example. First, determine the market rent for the property. This is critical and requires a healthy data sample of at least 5 or 6 properties in an active market. In doing this determination, similar properties should be used for comparison and adjustments up or down for individual property characteristics that differ from the subject property must be made. In addition, the rents used must be from arm’s length leases to be valid data.
Once the market rent is determined, the “gross rent multiplier” must be determined. This is done by taking similar properties which have recently sold in the market and dividing their monthly rents into their sale price. Eg. A property’s rent is $1500 a month and it recently sold for $175,000. Its GRM would be 116.67 ------ $175,000 / $1,500. Again, an average is derived from among the data sample you use.
The final step is to simply multiply the market rent for the property times the GRM you determined. For example let’s say the GRM above ended up being 119.5 and the market rent is $1,200. This example-property’s value by this method would be $143,400.
The Gross Income Multiplier
The Gross Income Multiplier (GIM) is handled in the same manner except that all of the properties’ income is used to determine the market income for that area.
Sellers Should Make Valuation Calculations Too
A final note is due here. While this article would seem to be targeted to buyers – understand as a potential seller this is what buyers will be doing to determine the value of the property as they contemplate an offer. Thus, as a seller it is wise to perform these same exercises in order to determine a realistic market price range that can be supported and to ready yourself for the forthcoming negotiations every offer brings.
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The information contained on this webpage is a generalized and broad discussion of typical valuation concepts and is meant to be for informational reference purposes only. While the general concepts are valid methods – there are additional concepts and information pertaining to valuations not covered herein. None of the examples are real or contain figures that have any correlation with reality or one another. Nothing contained on this webpage should be taken as advice or direction as to how you should investigate or proforma your own potential investments. You should always consult with your real estate professional, financial advisors and tax planners before making any real estate investment.
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