Over the last two decades, the world of real estate investing was opened to more people. No longer was real estate investing something reserved for the well-heeled, wealthy investors.
Writers like Robert Kiyosaki, an American investor, businessman, self-help author and financial literacy activist, exploded on the scene and whet the appetite of the average American for real estate investing. In his book, Rich Dad, Poor Dad, we learned the fundamentals of an investment strategy based on real estate. Real Estate legend and author,
Gary Keller, real estate entrepreneur and Co-Founder of Keller Williams Realty, changed the mindset of millions of Americans with three of his books, The Millionaire Real Estate Investor; Flip: How to Find, Fix & Sell Houses for Profit; and Hold: How to Find, Buy & Rent Houses for Wealth.
Financing became more readily available and often only required a minimum down payment. Everyday people across America became financially secure, wealthy and even multi-millionaires by utilizing the techniques and strategies described and demonstrated by gurus like Kiyosaki and Keller. Markets, however, are cyclical and the world of financing became, well, somewhat nefarious. Straw buyers, equity scammers, along with institutional greed made sure that this trend of easier money could not last forever.
The real estate bubble burst in the last quarter of this century’s first decade. 2007 brought us, not just a nation, but the world, into a great recession. It took a little while but the wise investor realized that the opportunities did not vanish; just the circumstances changed. Adaptation took hold and the fundamentals taught by Kiyosaki and Keller, was realized by many, to be true regardless of the flow of money and the recession. Profits can still be made. The financial institutions had to get a grip on their business models and employ safeguards and common sense.
With the change of conditions in the economy, specifically record high unemployment and under employment, along with tightened lending standards has substantially contributed to a boon in the rental markets. The market was witnessing record low vacancies across the United States. The saavy investors, those who ascribed to the techniques, strategies and principals of Keller and Kiyosaki, turned their attention from flipping to a hold for rental strategy. Along the way, so many have learned to fundamentals of making a flip work. Now people need to understand how to determine the value of rental properties for the buy and hold strategy. I this blog I endeavor to share with you some of the ways to value rental income property.
Sales Comparison Approach
The most recognizable form of valuation for residential real estate, the sales comparison approach (SCA) is simply a comparison of similar homes that have sold or rented over a given time period. An intelligent investor will analyze the SCA over a vast time frame to discern any trends which may be or have emerged.
The SCA relies on attributes to assign a relative price value. Price per square foot is a common and easy to understand metric that all investors can use to determine where their property should be valued. If a 2,000 square foot condo is renting for $1/square foot, investors can reasonably expect a similar rental income based upon similar rentals in the area. Keep in mind that SCA employs a somewhat broad spectrum; that is, every home has a distinctiveness that isn't always quantifiable. Personal preferences of buyers and sellers vary widely and are qualitative factors than are not incorporated into a simple, generic methodology that is SCA. The SCA is best used for foundational valuation, as a baseline or reasonable opinion and not a perfect predictor or valuation tool for real estate. It is also important for investors to use a certified appraiser or an experienced real estate professional when requesting a comparative market analysis. Never rely on the valuation provided by the seller or their representatives. Always have your OWN representation.
Capital Asset Pricing Model
The capital asset pricing model (CAPM) is a more comprehensive valuation tool for real estate. Risk and opportunity cost are primary elements of the CAPM as it applies to real estate investing. Using rental income and a comparison of the income to other investments with no risk, such as Treasury bonds, or to alternative forms of real estate investments such as Real Estate Investment Trusts [REITs], the CAPM model considers potential return on investment (ROI).
To simplify, it is a risk versus reward consideration. If the return on a risk-free or guaranteed investment exceeds potential ROI from rental income, why would you consider the accepting the risk of the rental property? With respect to risk, the CAPM considers the inherent risks to rent real property. For example, all rental properties are not the same. Location and age of property are key considerations. Renting older property will mean landlords will likely incur higher maintenance expenses. A property for rent in a high crime area will likely require more safety precautions than say a rental in a gated community. This model suggests building in these "risks" before considering your investment or when establishing a rental pricing structure. The CAPM helps you determine what return you deserve for putting your money at risk.
Income Capitalization Approach
Income capitalization converts anticipated cash flows into present value by "capitalizing" net operating income by a market derived "capitalization rate".
Essentially, a capitalization rate is a rate of return on investment much like a dividend earned on a stock. It is used by real estate investors as a benchmark for determining how much they should pay for a property. In appraisal practice, capitalization rates are extracted from "sales" of similar investment properties and applied to the net income of a subject property to determine it's value.
There are several ways to estimate value using "capitalization". These include direct capitalization and yield capitalization. The method used depends upon several factors such as the timing and regularity of the cash flows, period of time the investment is held, whether or not long term leases are involved, and so forth.
Direct capitalization is the most widely used and simplest approach to apply. It is used when income is not expected to vary significantly over time.
For example, direct capitalization would be used to value a 14 unit apartment building that produces a consistent annual operating income and has generally short term leases that keep pace with the market.
Direct Capitalization vs. Yield Capitalization. Direct capitalization typically involves the analysis of a single year’s net income (or average of several years income). The resultant "NOI" is capitalized by an overall capitalization rate to derive value.
Direct capitalization simulates investor motivation when reliable estimates of income and market derived cap rates are readily available in the market and reveal a consistent pattern. Use of direct capitalization does not require explicit projections of income and assumes that expectations for future income are similar for the subject and comparables.
Yield capitalization, on the other hand, requires explicit projects of income, holding period, and property reversion and generally considers the income streams for several years.
Yield capitalization does not necessarily rely on comparable sales but does require selection of an appropriate discount rate and considers the timing of recapture. Conceptually, yield capitalization involves the conversion of future benefits into present value by applying an appropriate yield rate to the various cash flows. These future benefits include any series of periodic incomes with or without a reversion (resale) of the property. In the determination of market value, typical investor’s yields are applied.
The Cost Approach is based on the principle of substitution which asserts that no prudent buyer or investor will pay more for a property than that amount for which the site could be acquired and which improvements that have equal desirability and utility can be constructed without undue delay. It is a method of appraising property based on the depreciated reproduction or replacement cost (new) of improvements, plus the market value of the site.
This approach has the most validity and/or reliability when improvements are new or near-new. For older or more aged structures, the cost approach may not be relevant due to the greater subjectivity involved in estimating accrued depreciation.
The cost approach begins with the determination of site value. Sales of vacant land with similar zoning, utility, and acquired for the same or similar use as the subject property being appraised, are analyzed. In markets where site sales are limited, other site sales of varying property type may be considered as long as they have core similarities in legally acceptable use.
Once site value has been determined, reproduction or replacement costs of the improvements are estimated as if the improvements were new. The estimate is then further adjusted for all elements of accrued depreciation including physical depreciation, functional and/or external obsolescence.
The cost approach to valuing real estate states that property is really only worth what it can reasonably be used for. It is estimated by summing the land value and the depreciated value of any improvements. Appraisers from this school often espouse the "highest and best" use to summarize the cost approach to real property. It is frequently used as a basis to value vacant land. For example, if you are an apartment developer looking to purchase three acres of land in a barren area to convert into condominiums, the value of that land will be based upon the best use of that land. If the land is surrounded by oil fields and the nearest person lives 20 miles away, the best use and therefore the highest value of that property is not converting to apartments but possibly expanding drilling rights to find more oil.
Another best use argument has to do with property zoning. If the prospective property is not zoned "residential," its value is reduced since the developer will incur significant costs to get rezoned. It is considered most reliable when used on newer structures, and less reliable for older properties. It is often the only reliable approach when looking at special use properties.
So Here We Are… The End of the Story…
There are fortunes to be made in Real estate investing, even in this economy. No doubt, the real estate market has changed substantially. Ignore the talking heads on late night television telling you that you can flip homes without money. All they mean is that you can flip homes without YOUR money but you still need OTHER PEOPLE’S money. Flipping homes financed with little or no money down is a relic of the past and possibly gone forever. Valuation has never been more important. Use the fundamentals of the qualified authors and this blog post to help get you in or back in the game.
Stay tuned for my next post where I will share with you how you can use your QUALIFIED money – that is your money which is invested, tax deferred, for your retirement, to invest in real estate. Imagine using your IRA to generate 16 or 17 % or more for your retirement savings rather than the abysmal bank or annuity offerings?
Thanks for visiting. Feel free to share this blog with any of your friends and family members who have an interest in real estate.
Charles McKenna, Commercial Real Estate Specialist
Licensed Real Estate Salesperson
KW Commercial of Keller Williams Realty Homes & Estates
400 Townline Road, Ste 145
Hauppauge, NY 11788