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Real Estate values are classically determined by qualified appraisers using 3 methods of valuation: Income, Comparison
and Replacement.
This brief is concerned with the Income approach, because anyone can perform this analysis quickly with just a bit of information from the seller of the property. If the initial analysis using the
Real Estate
Evaluator Spreadsheet (or pencil, paper and calculator) provides an outcome that is within your margin of interest, then you can feel confident of making an offer to purchase SUBJECT TO FACT CHECKING the cash flow data provided by the
vendor.
If you want to determine Comparitive value or Replacement value, make that a condition of your offer as well and either pay for a qualified independent appraisal or if financed, insist that your lender share their
appraisal with you. The Lender and you are partners.
The common back of the napkin calculations for quickly determining the value of real estate are the GRM and Cap Rate (Gross Rent Multiplier and Capitalization Rate).
Gross
Rent Multiplier (GRM) = Sale Price / Gross Revenue
Take the gross annual revenue (rents and other income like Laundry, Parking etc) generated by the subject property and divide that into the sale price of the property. The $463,500 sale
price of property divided by its gross income of $51,500/yr results in a GRM of 9. The property was priced at 9 times its gross revenue.
Compare that resulting GRM with other candidate properties. From a buyer's point of view, the
lower the GRM, the more undervalued the property is. A property with a low GRM and a potential for increasing the revenue is a property worth a second look. But the GRM considers only gross revenue and does not account for the expense
side of the income statement which may when probed, uncover potential negatives like property taxes that are just about to substantially increase. The second look should start with the Cap Rate. Cap (Capitalization) Rate
= NOI / Sale
Price
NOI is the Net operating Income and that must be derived from gathering the expense items and deducting them from the gross revenue to produce the net cash flow. That NOI is then divided by the Sale Price and expressed as a
percentage. So if our subject property had annual expenses of $21,780 (not counting debt service) then the resulting NOI of $29,720 ($51,500 less $21,780) divided by the sale price of $463,500 would produce a remainder of 0.064. Multiply
that
by 100 to express as a percentage and the Cap Rate will be 6.4%. A property with a 6.4% Cap Rate therefore will produce a property income yield of 6.4% in the first year. From a buyer's point of view, the higher the Cap Rate, the better the
potential return on investment will be. The Cap Rate calculation uses the income after expense including factors of vacancy, maintenance and management allowance and is a more reliable valuation metric to use in comparing the performance of one property to another. The Cap Rate can also be
used to compare a real estate investment to other income producing assets such as dividend bearing stocks and bonds. This is important to do if the real estate investment environment is uncertain. |
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One last measurement is required to fully understand the impact of a real estate investment.
Return on Investment (ROI) or Cash on Cash = NOI Less First Year Debt Service / Initial Investment (Down Payment Plus Closing Costs)
If the $463,500 property is 75% financed by a mortgage then the buyer comes up with 25% cash
($115,875) plus closing costs of legal, appraisal and registration ($4,125) for an investment total of $120,000. Meanwhile the NOI has now shrunk from servicing the annual mortgage payments of $16,800 resulting in an NOI after debt service of
$12,920 ($29,720 less $16,800). The ROI is the net annual cash flow of $12,920 divided by the first year net cash invested of $120,000 multiplied by 100 to express as a percentage yield of 10.8%. So although the property has a
Cap Rate of 6.4%, using a mortgage to finance, in this case, produces an ROI of 10.8%
If the buyer does not finance but
instead purchases with all cash then the same calculation is slightly modified:
$29,720 (NOI) divided by ($463,500 + $3,125) (purchase price + reduced closing costs) = .064 x 100 or a 6.4% ROI which is essentially the same
as the Cap Rate. Notice that the 75% financing scenario produces a much higher ROI (by 69%) and an even higher (by 126%) relative Real Rate of Return After Inflation where CPI is factored in. See
spreadsheet. This is why you need to calculate a property's cash flow using multiple variables.
Note the above does not account for income or investment taxes or inflation or loss or gain in equity. Consult your accountant, tax advisor and study the market you are investing in. Real Estate values do not always rise, income
streams are not always reliable and cash is subject to depreciation.
Asset price history reveals cyclical dynamics and reversions to the mean.
An accurate cash flow
analysis leads to better investments. The above
demonstration on GRM, Cap Rate and ROI is significantly enhanced if you have the most accurate data available. Make any offer to purchase subject to your examination and approval of
the documents that will verify income and expense.
They might be:
Owner or property manager records including service contracts and maintenance history. Copies of current lease and rental agreements. Correspondence with tenants and service suppliers. Owner's rental property
statement submitted to Revenue Collection to calculate income tax. City/Municipal records concerning licensing, legality and conformity to bylaws and regulations that might affect cash flow. Title Registration records of liens or encumbrances that
might affect cash flow.
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Determine:
If the current rents are under or over market rents. If the tenants pay on time. What vacancies have occurred and when. If the property vacancy rate is less or more than market
vacancy rates. What will affect the vacancy rate in the future. When the rents were last increased. When the property was last upgraded. If additional revenue sources such as Laundry and Parking can be improved or if they
require further investment. What the annual operating expenses are for:
Accounting, Legal or other Professional Fees Advertising, Signage and Promotion Common Area Utilities Maintenance and Repairs Management Fees Property Insurance Property Taxes Rental or Leasing Commissions Services (Garbage, Landscaping, Pest Control etc) Supplies
Use a Real Estate
Evaluator Spreadsheet |
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