Putting a value on investment real estate: how to determine what a piece of property is worth.
Well, what about fair market value? Fair market value is basically the price on which a willing seller and a willing buyer can agree on, assuming that each is acting with prudence, knowledge and under no undue force. This might be a good definition of value for the average investor, but value for a specific investor takes into account individual requirements, investment alternatives, tax rates and the ability to finance.
Many of you are probably familiar with the three basic approaches to value used by appraisers:
* The sales comparison approach compares the property being sold to similar properties.
* The cost, or replacement, approach determines what it would cost to replace the subject property, less depreciation.
* The income capitalization approach focuses on the cash flow of the property. Since cash flow is the No. 1 objective of private real estate investors, the income capitalization approach is the method most often used to at least establish an estimate of value.
There also are some ratios that investors like to use, including gross rent multiplier, or GRM (often used to value multi-family properties), the cash on cash ratio, the relationship between annual before tax cash flow and the amount of money the investor contributed from his own pocket, and the capitalization, or CAR rate which is the annual net operating income divided by the value of the property.
CAP rates are commonly used by investors to estimate value. All you need to come up with the value of the property using this method is the net operating income (usually referred to as NOI), and the prevailing CAP rate. Divide the NOI into the CAP rate and you get an estimated value.
Well, what is NOI? It is the cash flow of the property before mortgage payments and depreciation, less operating expenses, including property taxes, insurance, maintenance and repairs, management fees and utilities. Most lenders will also include capital reserves.
Where do you find a list of CAP rates? Unfortunately, they are not readily available in printed form. Brokers, lenders and appraisers have the best sense of what they are, but even they may disagree about them. However, we can make some generalizations:
* The higher the quality of the property, the lower the CAP rate
* The higher the quality of the tenants, the lower the CAP rate
* The higher the demand for the specific type of property, the lower the CAP rate
If you have two different types of properties generating the same NOI, but the CAP rates differ, the value will differ. Let's say you have a Class A office building and a "mom & pop" self-storage facility, each generating $150,000 in NOI. In our area, at this time, a Class A office building might command a 6 percent CAP, and a "mom & pop" sell-storage facility might command a 12 percent CAP. The calculations then tell us that the Class A office building is worth $2,500,000 ($150,000/.06) but the self storage facility is worth $1,250,000 ($150,000/0.12).
Looking at this another way, an investor in a Class A office building might be willing to accept a cash flow that represents only 6 percent of the price of the property, but an investor in a self-storage facility would want the same cash flow to represent 12 percent of the price of the property. The lower the CAP rate, the higher the value of the property.
CAP rates do not allow for important relevant investment factors, such as appreciation or depreciation, financial leverage or mortgage amortization, income taxes or risk.
Most value analysts go beyond the CAP rate method and utilize the cash flow model, which converts projected investment cash flows to a single amount, which then becomes a measurement of value and simplifies direct comparison of investment alternatives at a single point in time, allowing the investor to "compare apples to apples."
This would require a discussion far beyond the scope of this column, but the three typical methods used to calculate investment value are net present value, internal rate of return and capital accumulation. Each of these methods assumes variations in future income and expenses, the investor's discount rate and the CAP rate at the time of disposition of the property.
The investor's professional team members, especially the investment broker and the CPA, can run these calculations.
All of this is not as complicated as it might seem, but the advice of competent investment professionals should always be sought, especially since every situation is different, as are the objectives of the specific investor.
Please feel free to send general questions or comments and if space permits, I will respond.
Dan Scanlon is on investment broker with Grubb & Ellis\Coldstream Real Estate Advisors Inc., Bedford. He can be reached at 623-0100, or at firstname.lastname@example.org.
|Printer friendly Cite/link Email Feedback|
|Publication:||New Hampshire Business Review|
|Date:||Dec 22, 2006|
|Previous Article:||State sues for removal of abandoned barge from river.|
|Next Article:||Currier expansion project hits major milestone.|