Before you start to analyze property there is one “Rule” you should know about. Only after your real estate investment is under contract, should you prepare a comprehensive analysis that calsstatecompanies discuses in this article. Don’t waste your time and money before you legally control the property.
THE KEY FIGURE IN EVALUATING INVESTMENT PROPERTY
The key figure is the internal rate of return (IRR) after taxes. By comparing this figure with the IRRs from other investments, you will be able to determine the best investment for you.
It is critical to understand why the IRR is important when analyzing real estate investments. The IRR shows the time value of money, and it reflects cash flows based on present values. Return on investments, in terms of purchasing power, might actually be less, depending on how the cost of living has changed. Knowing the IRR will help to further quantify your investment opportunities.
Your analysis should be based on two types of returns, growth rate and replacement costs. Growth rate projections are based on historical trends. An analysis performed using this rate will give you a conservative IRR. An aggressive IRR is obtained by projecting a future selling price based on future replacement costs. Use both when analyzing buildings. Knowing both will give you an edge when negotiating.
What you should be looking for is steep growth. Buy complexes below the cost of replacement. Sell them when values are at least equal to or greater than replacement costs. This is how to become wealthy!
A SOUND DOWN-MARKET STRATEGY
In a down market, your strategy is to buy as far below current replacement cost as possible. To determine the current replacement cost, consult local building associations or your web site for the Marshall &Swift Valuation Service (M&SVS). M&SVS provides information on the construction costs of different types of buildings through-out the United States show how costs differ based on style for three types of buildings. Local square footage costs can be calculated using the conversion chart applicable to each area.
ANALYZING REAL ESTATE INVESTMENT
The methods to analyze real estate investments depend on the availability of information. They are as follows:
• Qualified appraisers
• Comparable sales data or “comps”
• Gross multiplier approach
• Capitalization rate method
• Essentials of real estate investment analysis software
We prefer using a specially designed computer program in conjunction with input from consultants and comparable sales data. Since the final decision rests with us, we want to be absolutely certain of our sources.
Qualified Appraisers
Appraisers use three appraisal techniques to establish the current market value. They are the (1) cost, (2) income, and (3) market data approaches. The cost approach establishes market value based on what it would cost to replace a reasonable facsimile. The income approach is designed to calculate the market value based on the expected future income. And the market data approach uses information gathered from recent comparable sales to determine value.
The appraiser considers all three methods when making a final determination as to current market value.
Comparable Sales Data or “Comps”
In a weak market, it is difficult to use comparable sales data to determine market value. Sales figures may not be available or may be stale because properties aren’t moving. Prices, under these circumstances, usually have no bearing on current market conditions. At best, comparables will give an indication of trends.
A sample of comparable sales information from the CoStar Group shows how the information is presented. Local real estate boards can be of further assistance.
Gross Multiplier Approach
The gross multiplier approach is the ratio between the gross rents and the selling price. By comparing gross multiples of other properties in the same general area, a rule-of-thumb determination of market values can be made.
Capitalization Rate Method
The capitalization rate is the ratio between the net income and the selling price. This rate can also be compared to those of other buildings in the same neighborhood. Capitalization rates should be adjusted to reflect the following:
• Liquidity: How fast can you get your money out?
• Risk factors: What is the degree of safety?
• Tax benefits: How much money will you save on taxes and when?
• Ability to borrow money: Is it easy to get loans on the real
estate investment?
• Degree of management activity: How much time do you have to put into
managing your investment?
• Expectation of appreciation: What is the potential of this real
estate investment?
We generally don’t purchase buildings with a capitalization rate under 8.5 percent. However, depending on the weight of these factors, we would consider a lower capitalization rate. Adverse conditions cause the capitalization rate to be adjusted higher; favorable conditions cause it to be lowered.
Essentials of Real estate investment Analysis Software
Choose a computer program that fits your needs. You should select software capable of providing the following features:
• Projections and analysis of cash flows and tax benefits using the IREM
format
• Maximum forecasting flexibility
• After-tax IRR
• User friendly
A computer program that has these features makes it easier to analyze properties. If the data is accurate, your reports will supply you with the necessary facts to make the right investment decisions.
When inputting data, numerous assumptions must be made. There’s an expression that communicates the importance of inputting good data. If data submitted to computer operations came back stamped “verified,” it meant it was accepted. Reports stamped GIGO meant the opposite! GIGO stands for “garbage in garbage out.” The same applies to investment data. If the information inputted is garbage, your out put will be the same.
The computer program should be designed to give an IRR based on specific assumptions. Confer with your consultants to assist you in making these assumptions. For example, estimates of tax rates and depreciation should be made with the help of your tax advisor. When speculating on general business conditions in the area, your real estate investment manager or real estate broker should be consulted for advice. These professionals must be able to provide you with the data needed to make the right assumptions.