There is a multitude of methods that can be used to evaluate real estate and the one a buyer chooses should depend on the type of property they are considering and their investment goals. Last month, I delved into an explanation of cap rates and how they are used to measure investment performance for commercial real estate.
A cap rate is a great tool for evaluating property with income, but it may not be the best choice if the property does not have steady rents, predictable expenses, or is purchased with financing. Knowing the methods and choosing the best valuation technique suited for a particular situation will help ensure a buyer’s investment goals are reached. Here are six other methods of evaluation that buyers should consider using when thinking about a real estate purchase:
Comparable Sales Method – Often used for residential properties and those without an income stream, studying comparable property sales is a great way of determining a non-income producing property’s value. This method examines similar properties and makes adjustments for the property location, size, age, and other features to determine the subject property’s value. As we have seen in the current residential market, supply and demand influence pricing. The comparable sales method captures the current market trends when income is not a factor and is a good method for evaluating vacant land values.
Return on Investment (ROI) – ROI is one of the most important factors to look at for investment real estate. Cap rates are one of the most widely used methods for determining a property’s income potential, but they are limited to a one-year snapshot of the property and they do not include an analysis for financing even though most properties are purchased with leverage. Here are three other ways to evaluate a property’s return on investment:
Cash-on-Cash – This is a method that factors in financing by looking at the investor’s return based on the cash they have invested in the real estate, instead of the total purchase price of the property. If a property costs $1,000,000 and a buyer finances $800,000, the buyer commits $200,000 of cash. If the property has a net operating income (NOI) of $90,000 per year and the principal and interest payments are $55,000/year, the buyer will receive $35,000/year. The investor’s cash on cash return is 17.5% annually ($35,000 in income divided by $200,000 investment = 17.5%). A cap rate analysis would show this was a 9% return based on an all-cash purchase ($90,0000 divided by $1,000,000). When interest rates are low, the cash-on-cash return is often much higher than the cap rate, allowing the investor to leverage higher returns on their money. When interest rates are higher and approach the cap rate or exceed it, the cash-on-cash return will be negative and leverage may erode the investor's ability to earn a positive return on the asset.
Discounted Cash Flow – This method can be used with cash-on-cash and is a method that calculates future income based on changes in rent, vacancies, operating expenses, and one-time capital expenses. It is used to determine the amount of money an investor would receive, adjusted for the time value of money, which assumes today’s dollar is worth more than the future dollar. If the expected cash flow is $35,000 this year, $40,000 next year, and $45,000 the third year and we use a discounted cash flow rate of 3% (assuming inflation will run about 3% or that we could earn 3% on alternative investments) we can determine the DCF. The current value of the future cash flows would be $35,000 plus $38,835 ($40,000 divided by 1.03) plus $42,417 ($45,000 divided by 1.03 twice), which is $116,252. When we annualize this figure, it averages $38,750 per year, which would be a cash-on-cash return of 19.4% based on our previous example of a $200,000 down payment.
Internal Rate of Return (IRR) – This is an approach that takes the two previous methods and adds factors such as the holding period (the value when the property is sold) and changes in rental income/expenses on an annual basis. This is a more robust method for determining value and is very useful when investors have different anticipated holding periods for their real estate. The CCIM model uses IRR for comparing investment properties; and I find this the best method for determining long-term projections of an investment. It can get quite complex and is best demonstrated on an excel spreadsheet that shows annual cash flows after expenses, principal and interest, and then a final payment that includes the cash received after selling the property and paying off the remaining mortgage. These cash flows are then used to determine the rate of return an investor would receive based on the initial investment in the property.
Gross Rent Multiplier (GRM) – This is a simplified method that can be used to appraise properties based on income and does not include expenses. GRM may be useful when expenses are not reported, not accurate, or vary greatly from property to property. This is the case when a property is not managed well or when an owner might be taking a salary that is not commensurate with the amount of time worked. It may be helpful for an apartment investor that knows what their expenses run and they use the income to determine the value. For example, let’s say commercial property sold for $1,000,000, with an annual income (before expenses) of $200,000. To calculate its GRM, we divide the sale price by the annual rental income: $1,000,000 ÷ $200,000 = 5. Assuming the GRM is 5 for other similar properties, we can then determine that if a property has an income of $150,000, it should be valued at $750,0000 (income of $150,000 multiplied by GRM of 5).
Cost Approach – This is the best method for new construction or a specialty use building such as a school, church, or club. The value is derived from a land value and the cost to build the existing structure on the property. The cost of new construction is then depreciated based on the age of the property to determine a fair market value. This method does not look at the income, so it is not often used for investment properties; but it is very useful in some instances, such as appraising the value of a building that is to be built or just recently completed, but not yet rented.
Knowing some different evaluation methods can help an investor decide which will be best for their specific scenario. Countless other methods may be considered such as cost per door (a quick initial approach for large hotels and apartment complexes) and cost per rentable square foot. This list is not meant to be all-inclusive but is a good introduction to knowing different methods, and using the right one can be vital to the long-term success of the investor.