Evaluate investment property with head, not heart.

To buy or not to buy? The decision on whether to purchase an investment property is an important one with long-lasting impact on your finances.

That's also why such an important decision should be based on sound analysis and assumptions, and not on emotion. It is easy to fall in love with a potential property or the potential of a property, but it is important not to buy until a true assessment of the value of the property is made. It sounds like common sense, but all too often, a buyer comes to the table with his/her "heart in hand" rather than the facts.

There are a number of methods used by both buyers and sellers to determine a reasonable purchase price. These methods include:

* Determining the "cap rate" of the property.

* Calculating the multiple of the rent roll.

* Determining the price per square foot (i.e., the "bricks and mortar" cost of the property).

* Calculating the price per unit and price per room (rental property).

Cap Rate

The capitalization rate (cap rate) is the rate of return expressed as a percentage that an investor expects to realize on his/ her cash investment. It is applied to the net operating income (NOI) of the building to determine a value.

There are a number of factors that affect cap rates, including:

* Risk. The higher the risk, the higher the cap rate required.

* Interest rates. Generally, a rise in interest rates is matched by a rise in cap rates

(in order to compensate for the higher cost of money).

* Appreciation potential. The cap rate on a building may be lower if it has significant potential upside. For example, a building with rents below market value will usually sell for a lower cap rate than a building with rents at or above market rates.

* Demand. The rule of supply and demand affects the cap rate as well: the greater the demand for the property, the lower the cap rate.

* Alternative investments. Cap rates for real estate are affected by the investor's rate of return on other investments. If the investor can achieve a high return rate on other investments, he/ she will expect a higher rate of return on real estate investments.

Multiple of Rent Roll

As the term indicates, this calculation applies to residential properties and is the easiest calculation to make. The purchase price is expressed as a multiple of the gross rent roll (GRM). A building with a $500,000 rent roll and a sales price of $5 million has a GRM of 10.

It is important to note that the average apartment rental has a direct impact on the multiple: If average rents are low, the property will sell for a higher multiple because the property has greater upside potential. However, be careful when using this method since it does not take into account NOI and only bases the price on gross revenue. Although gross revenue is high, net income could be low due to higher expenses such as fuel or insurance.

Price per Square Foot

Price per square foot is probably the most common way individuals look at a potential investment. But it is important to note that the calculation on some buildings must be made in two ways. First, simply divide the purchase price by the square footage of the building. Simple enough.

If, however, the building has air rights, a second calculation should be made for the price per "buildable square foot." This calculation is made by dividing the purchase price by the total buildable square feet available at the property.

Price per Unit

Another way to determine the value of the property is to calculate the price per unit and price per room. This calculation will be most useful if trying to determine the conversion potential of a residential rental building or hotel.

In addition to these measurements of value, there are other factors to consider as well, such as replacement cost, "comps" (the sales cost of comparable buildings in the area), and Internal Rates of Return (IRR). The IRR calculation is used for more complex transactions, requiring the preparation of a cash flow projection over an extended period (usually 10 years or more) and introducing the timing of income and expenditures to determine the ultimate sales price.

These methods are not mutually exclusive and they are used by both sellers and buyers. When making a large investment, it is important to go into the evaluation and negotiation of the property with as much solid information as possible. A combination of these tools provide just that to the potential buyer and seller.

Also, because of the complexity of the transaction and its long-term tax ramifications, it is important to consult with your attorney and accountant before finalizing a purchase.

By MARC WIEDER, CPA 

ANCHIN, BLOCK & ANCHIN LLP