Understanding the mysteries of Net Operating Income
Delving into cash flow
Looking at three basic approaches to valuation
Determining what you should pay for a property
With the help of your real estate team, you should narrow your real estate investment opportunities down to just those properties that seem to have the best chance to produce financially in the long run. In Chapter 11, we cover the basics of property valuation and provide you with the information you need to examine the leases of prospective properties.
In this chapter, we get down to the business of running the numbers. We cover the essential elements of understanding and arriving at a property’s income and expenses and Net Operating Income — and we explain what that is! We then take these important numbers a step further and show you the best valuation tools traditionally used by appraisers and commonly used by lenders to determine what a property is worth.
But after you’ve done all of your research and analysis, the reality is that you still need to establish whether a proposed property has the potential to be a good investment opportunity. Overpaying for a good property isn’t any better than getting a deal on a bad property. Neither will meet your goals. So we close the chapter by putting it all together to help you decide how much you should consider paying for a particular property.
Understanding the Importance of Return on Investment
The purchase of an investment property is really the purchase of a future income stream or cash flow. Although pride of ownership or the satisfaction of being the owner of a rental property may be an important issue for some people, most real estate investors focus primarily on the investment returns that they can generate from a given property.
Four elements determine the return you see on your investment:
Net cash flow:Net cash flow is money generated by the property after deducting all costs and debt service from the income. See the “Calculating Cash Flow” section later in this chapter.
Tax benefits of depreciation: Many investors are able to use these tax benefits to shelter other sources of income which gives you in essence an interest-free loan by deferring taxes (we cover this subject in Chapter 18).
Buildup of equity: If you acquired the property with debt, the equity buildup from paying down the debt over time is a factor.
Appreciation: True wealth is created through appreciation (buying property and selling it years later for much more than you paid). Significant estates and generational wealth are created through appreciation.
The key to generating a profitable real estate portfolio is finding and purchasing properties that exhibit the potential for high occupancy and growth in income while keeping expenses and turnover reasonable. Success in real estate investing depends on purchasing a property for the right price so that you have the ability to use your management skills to increase the value over time. Don’t base your investment decision on emotions. Falling in love with a property can lead to overpaying.
You also need to determine what work needs to be done to the property to correct any deferred maintenance or curable functional obsolescence. Even if you simply hold the property and look for cash flow and appreciation, you want to be able to evaluate the holding costs during your ownership period.
Then you need to determine the future value of the property to calculate the likely disposition price and determine your return on investment.
Figuring Net Operating Income
Knowledgeable real estate investors begin a serious analysis of a potential property acquisition by determining the projected Net Operating Income, commonly abbreviated as NOI. We find it surprising how many real estate investors don’t make the effort to calculate the NOI before buying a property. Instead, the quick-and-easy nature of the benchmarks we cover in the previous chapter seduces unwitting investors into a false sense of security.
The calculation of Net Operating Income is simply
NOI = Gross Operating Income – Operating Expenses
NOI is the most critical factor in determining the potential for return on your investment in real estate. Determining the NOI of a property is one of the fundamental building blocks to analyzing real estate investments. Any decision — to buy, hold, or sell — should only be made after a careful analysis of the actual current and projected future NOI for a given real estate investment. Arriving at a reasonable estimate for future NOI is the key to determining the value parameters for your real estate investment. We recommend that you value a property based on the projected NOI for the next year, or preferably next few years.
The current NOI is fairly easy to obtain and is often provided by the seller (although in the rest of this section, we explain common problems with this seller-provided data). Deriving the projected NOI is a more time-consuming and in-depth process. The forecasting of a property’s NOI is more of an art than a science. Many times, the estimation of NOI is based on a number of assumptions or projections about future events that are anything but certain. Will your tenants renew their leases (and at what rates)? Will the tenants make their rent payments and other contractual requirements as agreed in their leases? Will expenses stay within the expected range, or will there be significant world or local events that lead to a spike in costs (like the availability and cost of property insurance in the aftermath of the 9/11 terrorist attacks or a significant increase in the price of oil)?
Whether you receive current or projected NOI estimates from a seller, be careful to verify the numbers. Some sellers, and many real estate brokers and agents, prefer to provide a pro forma NOI (a projection of future financial performance of the property) that uses higher rents and lower expenses. These fictitious numbers are based on the hopeful theory that the new owner will raise the rents to market level and simultaneously lower the costs of operating the property. These assumptions are rarely valid. Unless the property has leases with built-in rent increases or that can be renewed at higher rates or below-market leases that are expiring while the demand is high, you seldom find a professionally managed property with below-market rents. If it were that easy to increase income, wouldn’t the current owner do it? Expenses are also unlikely to decrease significantly unless you have an older property where a lighting or HVAC retrofit will decrease energy usage.
Some owners of rental properties with above-market leases coming up for renewal or some owners who know their expenses will increase dramatically will be tempted to sell their property using historical numbers. You need to consider historical numbers, but the most critical information to determine the value of the building to you as a potential new buyer is future income and expenses.
Have you ever seen a projection from a seller, her broker, or her sales agent that projects a lower NOI for an investment property on the market? They act as if the only way for NOI to go is up. Although you want to invest in properties where that is the likely result, the reality is that real estate is a cyclical business, and supply and demand factors have a major impact.
“Garbage in, garbage out” holds true for your projections of your future NOI. Therefore, make a careful and detailed analysis of the property you’re considering. Real estate investing isn’t something you should do by the seat of your pants. Develop your own operating pro forma prior to purchasing any property. And any evaluation or projection of the income stream for a property should begin with an analysis of each lease or rental agreement (which we cover in Chapter 11).
Evaluating income
To evaluate the income side of your budget, we advise that you painstakingly record and verify all income by using a zero-based budget concept. A zero-based budget is where you start with a blank piece of paper (or spreadsheet, if you enjoy computer software) and individually, tenant by tenant, create the projected rents and income stream for the property. (A similar zero-based budget concept is useful for determining your likely or expected expenses and is discussed in further detail later in the chapter.)
Sellers may provide or be asked to sign a certified rent roll or comparable document verifying the accuracy of the tenants and rents listed. Although this document may be a great exhibit in your lawsuit against the seller for fraud, we advise that you use this document cautiously. Conduct your own independent analysis of the current and future rent payments due under the terms of the existing leases. Don’t just gather static data and numbers on your current tenants; you must be able to interpret the data. Evaluate the strength of each tenant. The lease may give you the legal right to future rent payments; however, a tenant who is unable or unwilling to meet his lease obligations won’t be good for your rental collections.
You want a property that has tenants who not only have the current financial strength to meet their obligations under the lease but who will also enhance or increase your income in future years. For example, you may determine that one of your commercial office building tenants will be looking to expand and will probably replace a tenant that is barely surviving and unlikely to renew their lease.
It’s truly amazing how little some commercial landlords know about the needs of their current tenants. Be sure to actually talk to your prospective tenants (in addition to getting the estoppel certificates discussed in Chapter 11). Tenants are the key to your future success, and you want to make sure that you can provide the proper environment so their businesses can grow and prosper while you benefit from their rental payments, which ultimately pay for the building you plan to own free-and-clear in the future.
But the income side of the equation involves more than just estimating rents. The typical income and expense statements for reporting in real estate include standard terminology that all real estate investors should know:
Gross potential income or GPI is the maximum gross income that would be generated from the rent if the property were at 100 percent occupancy and all money owed were collected in full. (This is sometimes referred to as gross possible income.)
Effective gross income or EGI is essentially the money that is actually collected. EGI is calculated by taking the GPI and then subtracting the vacancies, concessions, delinquencies, and collection losses and then adding the other income from late charges, returned checks, and all other secondary or non-rent sources.
In the sections that follow, we provide the details on what to subtract and add to work your way from GPI to EGI.
Accounting for vacancies
The real estate investment community seems to be locked on using 5 percent as the vacancy factor; brokers and even lenders typically use a 5 percent vacancy factor without any regard for the actual market conditions. This number may or may not be the right number to use; we advise that you carefully determine the most accurate estimate of future vacancy rather than use a standard figure such as 5 percent.
The issue of vacancies is particularly applicable to many new real estate investors who begin either by retaining their current homes as investment properties when they move up to larger homes or by purchasing rental properties as investments. Novice investors often simply compare the monthly rental rate that they plan on charging to the monthly costs for paying the mortgage and any other recurring expenses (property taxes, utilities, homeowner’s dues, and so on). This practice can be dangerous if you don’t have sufficient cash reserves for the unexpected — like being unable to find or retain tenants or having to evict a tenant who stops paying.
An eviction is particularly disruptive to your cash flow because you not only don’t collect any income, but you also have the expenses of legal fees, court costs, and the costs of preparing the rental rate for the next tenant (plus vacancy) until the new tenant moves in and begins paying rent.
If you have a single-family rental home, the property is either occupied or vacant. With the average length of residential tenancies in many parts of the country at less than one year, using a 0 percent vacancy factor is unrealistic. Our suggestion for your pro forma for a single-family rental home is to anticipate a loss of income equivalent to one month per every 12 months, which reflects an 8.3 percent vacancy rate. This rate may represent a vacancy, a delinquency, or a concession (see the following sections), but our experience indicates that, one way or another, you’re likely to lose at least one month’s rent/income on average per year, and you should allow for this prospect in preparing your pro forma to determine the potential income before making your investment decision.
Calculating concessions
A concession is any benefit or deal-sweetener offered by the landlord to entice the tenant to enter into a lease or rental agreement. Concessions can be anything of value that motivates the tenant, but most commonly include free or reduced rent or additional features (a ceiling fan, microwave, upgraded finishes, extra parking, and so on). In many areas, concessions are a significant factor in estimating future income. Remember that a concession of one month’s free rent is essentially an 8.3 percent discount of the annual rent. A free month’s rent for a simple residential tenancy with a monthly rent of $1,000 means that you’ll only collect $11,000 in the first year, or an effective rental rate of $916.66, or a concession rate of 8.3 percent. This reduction is a significant factor when added to your expected vacancy rate and allowance for collection loss (see the next section).
Deducting delinquencies and collection losses
The industry standard for collection loss (rent or other charges that the landlord must write off as uncollectible) is typically 0.5 percent of rental income. This is another number that seems to be acceptable as a general rule; however, savvy real estate investors make their own analyses of the actual collection loss they may experience based on the strength of the tenant, the strength and depth of the local job market, the average turnover of the area overall, the amount of security deposit they hold, and the nature of local tenant/landlord laws. For example, collection losses for residential properties in the Las Vegas area often exceed 2 to 4 percent, and the continued advent of pro-tenant legislation in California and other major metropolitan areas foretells increased losses to landlords because of the inability to evict nonpaying or disruptive tenants.
During a weak economic environment, collection loss can be even more significant, and prudent landlords take steps to make sure that they have financially sound tenants who can pay rent. The competition for these qualified tenants means that you may have to lower the rent or offer concessions, which are better options than trying to get top dollar from an unqualified tenant. Remember that the best qualified prospective tenants or applicants in a weak market will be in high demand from other rental property owners who are your competition.
Adding in additional income streams
In addition to rent, other types of payments are essential elements to your income stream. Other income items can consist of late charges, returned check charges, and various ancillary income items. The ancillary items depend on the type of investment property, but for residential properties, they can consist of laundry, parking, vending, Internet services, storage, concierge service, and so on. Examples for commercial properties can include sources similar to those for residential properties, plus items like common area maintenance charges (CAM), supplemental HVAC (heating, ventilation, and air conditioning) charges, special security requirements, and telecommunications.
Tallying operating expenses
Just as you did with your income, use a zero-based budget concept to forecast the projected operating expenses for your property. Although historical expenses are worth reviewing and sometimes can be quite accurate in forecasting future expenses, we recommend that you question every expense. Who knows, you may find that the current landscaper is actually willing to charge you less just to keep the account. Or maybe you have contractors and vendors you already use who will charge you less.
The income and expense information presented by most owners or their real estate agents doesn’t accurately reflect the current financial results. Inevitably, they may claim that the rents are too low and they may show artificially lowered operating expenses in order to inflate NOI. As the potential purchaser of this property, you want to deal with reality, so be sure to require the seller to provide you with a copy of her federal tax return Schedule E for each year of her ownership — or at least the last several years. Rarely does the tax return overstate the income or understate the expenses of a rental property — and you want to base your decisions on fact, not fiction.
Utilities
Evaluate your utility costs as soon as you can, because this expense is typically one of the larger costs of operating your property and is also subject to significant increases. Determine the current and projected rates for the utilities by contacting the service providers for electricity, natural gas, water and sewer, telephone, cable, waste removal, and any other utilities that are provided at the property. Virtually all of these utilities are regulated locally or at the state level and must file future rates well in advance.
Thus, determining the future cost for utilities is relatively easy if your usage remains the same. But seriously consider any energy and resource efficiency improvements that you can make, such as lighting, low-flow toilets, automated sprinkler, or drip irrigation systems, and other ways to reduce the consumption and provide incentives for your tenants to conserve.
One sure way to get tenants to conserve is to make them responsible for paying for their own utility usage. This approach can dramatically improve your NOI, and it’s often a win/win situation because many tenants make long-delayed energy-efficient changes to improve conservation practices. You can make these changes in a number of areas:
Electric usage: Robert dramatically improved the NOI for one of his client’s commercial office buildings by more than $100,000 per year simply by installing separate electric meters and requiring the tenant to pay for his own electricity. The significant improvement in NOI occurred even after the tenant was given a reduction in the rental rate based on the utility company’s estimate of a reasonable monthly expense for electricity for that suite. The tenant was a food broker and had 12 large, inefficient freezers that helped to generate a monthly electric bill of more than $15,000 — paid by the landlord. Surprise, surprise — when the tenant began paying for its own electricity, it quickly cut the number of freezers in half and invested in new energy-efficient models.
Water usage: Across the country, individual water meters are being retrofitted for each residential tenant. An EPA-sponsored three-year study recently concluded that billing residents for their water usage by direct metering can reduce annual water consumption by an average of 15 percent. In temperate climates, landscaping is the single largest consumer of water. Converting to drip irrigation or recycled water (if available) can dramatically reduce water consumption and thus your cost.
Waste collection and disposal: This category is quickly becoming the next major cost item that landlords are passing on to tenants because these costs are rising rapidly in most areas of the country.
We recommend that you limit your investments to residential and commercial buildings with separate meters for water, sewer, and electricity (see the “Surveying Lease Options” section later in the chapter).
Management fees
A common mistake made by many investors is failing to incorporate the value of their time if they self-manage their property. Your estimate of operating costs should include a management fee even if you self-manage. Your time is worth something, and there is an opportunity cost (whatever other productive activity you could be doing with that time) as well. Also, you may decide in the future to hire a property manager so that you can focus on the acquisition, improvement, and disposition of your real estate holdings. Including a comparable management fee now saves your projections from taking a hit later. See Chapter 15 for more on hiring a property management firm.
Insurance
Like utilities, property-casualty insurance is another major operating expense for which you need to get a specific quote for future projections instead of relying on historical data provided by the seller. Insurance coverage and rates can vary widely from one insurance company to another and there are also many opportunities to benefit from package or volume purchases of insurance. See Chapter 16 for the scoop on risk management.
Other operating costs
Don’t forget all of the other operating costs for your property, including your outside vendors that provide services. You may have landscaping, pest control, parking lot sweeping, painting, cleaning and janitorial, and other services. Contact each firm for pricing — and put these services out for competitive bids when you feel that the pricing and services offered aren’t the best values.
Be sure to get current bids for all of the other expenses of owning and maintaining your property. For maintenance, you can look at historic numbers, but you want to keep the age and condition of the building in mind when setting your budget for upkeep.
Almost every real estate investor at some point considers purchasing a property that the seller claims has been fully renovated. The seller implies that because many of the building components are new, the required maintenance expenditures are nominal and your operating and capital expenses will be lower. Our experience is that even properties that have been recently renovated still have ongoing maintenance needs. Don’t cut back on, or fail to allow sufficient funds for, ongoing maintenance and repairs when you crunch the numbers.
Calculating Cash Flow
As you begin to look at various properties that you may want to acquire, you discover that the real estate investment community always refers to the NOI of a given property and commonly uses that number to set the value or asking price of a property. The NOI is the number that tells you what you can afford to pay for the property. We show you the calculations in the “Figuring Net Operating Income” section earlier in this chapter.
However, don’t confuse the NOI with cash flow, which is NOI minus debt service payments and capital expenditures (for example, new roof, appliances, floor coverings, and so on). In the example in Table 12-1, the Net Operating Income is $600,000, but the actual cash flow before taxes to the investor is $150,000.
After you have your NOI, you can project your annual cash flow. The formula is straightforward:
NOI – Debt Service – Capital Improvements = Before-Tax Cash Flow
Servicing debt
The broker information sheet (or sales flyer) on an available property may provide proposed financing. However, make sure that the debt service projection in your income and expense pro forma relies on a firm financing commitment that you have received.
Although the annual debt-service payments are a direct result of the amount of the purchase price borrowed, for most conventionally financed properties, the debt service will be 80 to 90 percent of the NOI in the early years of your ownership of the property. If you have fixed-rate financing, the debt service is going to be an easy number to plug into your income and expense pro forma because the payment won’t change. However, if you have an adjustable rate mortgage, you’ll need to estimate future interest rates and debt service payments to calculate future cash flows.
Making capital improvements
In developing their estimates or pro formas of projected financial results for a proposed investment property, many investors neglect to account for, or seriously underestimate the need for, capital improvements to the property. Capital improvements are the replacement of major building components or systems such as the roof, driveways, HVAC, windows, appliances, elevators, and floor and window coverings. Real estate investing requires planning and the allocation of money to protect and preserve your property investment in the long run.
Often sellers indicate that the property had been fully renovated and imply that the purchaser won’t need to make any capital improvements for many years to come. But buildings age and things wear and break — especially in rental properties. Just as homeowner’s associations often are wise to put aside funds each year in a reserve account for capital improvements, you should allocate a portion of your income to reflect the fact that certain components of your property are deteriorating over time and will need to be replaced. Otherwise, you may find that your roof needs to be replaced and you don’t have the funds to cover the expense.
Capital improvements are also an essential component of the repositioning or renovation plans that lead to improved financial performance for investment real estate. As an investor, always consider properties that owners have neglected to properly maintain and upgrade. This category is one of the best target markets for investing, and your pro forma income and expenses should contain a realistic capital improvement budget.
Your pre-purchase due diligence should include a detailed walk-through of the property by a qualified contractor who can identify health and safety issues that should be addressed immediately — either during escrow by the seller or by you as the new owner. A leasing broker or someone knowledgeable about the competitive properties in the market should then compile a prioritized list of needed work and cost-effective upgrades that will position your property to deliver above-market returns.
This important feedback should be documented with written summaries by suite or unit number, plus a detailed evaluation of all common areas to bring the property into consistency with your overall marketing plan. Then contact the appropriate suppliers and contractors to formulate a capital improvements budget by month or year.
Even with the most diligent walk-throughs and cost estimates, the reality of property renovation and repositioning is that the costs typically exceed your expectations and the timelines are rarely met.
The capital improvements or reserves for replacement vary based on the age, location, and condition of the property, as well as the tenant profile. The higher the turnover of tenants (and the less money the prior owner has invested in properly maintaining the property over the years), the higher the capital expenses. A location impacted by climatic conditions can also be a significant factor in the life span of building components. For example, properties located in a marine climate require more frequent painting and replacement of items affected by moisture and corrosion.
Capital expenses are subjective. Our advice is to be conservative and estimate toward the high side of a range. If you don’t have to spend the funds, your real estate investment results are enhanced. But you don’t want to plan on scrimping by not addressing needed repairs and replacements. Deferred maintenance is more costly to address in the future, plus it ultimately negatively impacts on your income if your property doesn’t attract financially strong and stable tenants.
Surveying Lease Options
Leases for rental properties come in three basic forms:
Gross lease: In a gross lease, the landlord pays for almost all of the operating expenses of the property.
Modified gross lease:Modified gross leases pass some of the expenses of owning and operating the building directly to the tenants. Examples of modified gross leases include leases where the landlord pays all operating expenses except for certain items such as utilities, parking, or janitorial expenses.
Net lease: The term net lease can have an unlimited range of variables but typically provides for the tenant to pay for the majority of the costs of operating the building, including property taxes, insurance, and maintenance costs. Those leases in which the tenant pays virtually all costs associated with operating the building are called triple net leases.
You shouldn’t include the cost of any tenant-paid services as an expense of the property. The leases for a commercial property can be gross leases, modified gross leases, or net leases, but residential properties are almost always leased on a gross basis, except utilities.
Comparing some of the options
There are different thoughts about which type of lease is best. Many investors believe that net leases reduce the owner’s management of the property, but this assumption isn’t necessarily true. The owner must still ensure that the property is properly maintained. One argument against net leases is that the tenant may skimp on the maintenance of the property, which is why you typically don’t see net leases in residential properties. Can you imagine a residential tenant being responsible for all of the maintenance of his rental home?
We find that modified gross leases in which the tenant pays for expenses that she can control are a good balance for all types of properties. The following shows essentially how the relationship is structured in most apartment buildings:
The landlord retains control of the property maintenance and makes the necessary repairs and upgrades inside and out to ensure the long-term integrity of the building instead of allowing it to be compromised by thrifty tenants. The landlord is also able to ensure that the assessed value is kept low and the property taxes are paid on time, plus make sure that proper insurance coverage is in place.
However, the landlord doesn’t control certain expenses that are better suited to be paid directly by the tenant. For example, tenants have a direct impact on the utility usage and are more careful to conserve if they pay that expense. This is why we recommend you limit your investments in residential property to those buildings with separate meters for water, sewer, natural gas/propane, and electricity. Likewise, some commercial tenants can live with weekly janitorial service rather than daily if they’re paying the cost directly.
As the potential purchaser of a commercial property, carefully evaluate the leases and determine what operating expenses, if any, are paid by the tenants. You need to understand whether the property is using gross or net leases. Otherwise, you may be deceived regarding the actual NOI and cash flow that you will receive for the property.
Clearly, the rent charged for commercial properties with net leases, where the tenants are directly responsible for making the property tax and insurance payments and where they handle their own maintenance, will be lower than a similar property with a gross lease. But the end result may be similar because the higher rents received on the gross lease property will go toward those same expenses and costs that the tenant is paying at the net leased property.
Accounting for common area maintenance charges for commercial buildings
Costs in multitenant commercial buildings that are passed on to the tenant are called common area maintenance (CAM) charges. Paid proportionately by each tenant for the upkeep of areas designated for the use and benefit of all tenants, CAM charges include items such as parking lot maintenance, security, snow removal, and common area utilities. These charges are part of the tenant’s rent and can be due in advance or paid in arrears; the lease establishes the terms. Some tenants negotiate that they don’t have CAM charges. For accounting purposes, CAM charges are typically reflected in the cash flow as “CAM reimbursement” (see Table 12-1). Although they’re indicated as an income item, they’re essentially offsetting the corresponding expense items included in the operating expenses for the property.
The most common method is to use an estimated annual budget for the property as a basis for the collection of a monthly CAM charge. At the end of a previously agreed upon time period (usually annually), you calculate the actual expenses incurred for the common area items and reconciled against the amount actually paid by the tenants, billing the tenants for any shortfall or refunding any excess payments.
Handle the CAM reconciliation as soon as possible after the accounting is complete for the relevant time period in order to quickly collect any funds due, as well as to provide feedback in case the future estimates need modification.
The Three Basic Approaches to Value
Professional real estate appraisers traditionally use three basic valuation techniques to arrive at an accurate estimate of current value: the market data (or sales comparison) approach, the cost approach, and the income capitalization approach.
Typically, each valuation method arrives at a slightly to moderately different estimate of value, and the appraiser reconciles or weighs the different results based on the applicability or reliability in determining the final estimate of value. The appraiser’s derived estimate of value may be greater or lower than the price a particular investor is willing to pay — the investment value. But lenders require appraisals to protect their position and show that the property has sufficient equity so that if they’re suddenly forced to foreclose and sell, they’re less likely to suffer a loss. In the following sections, we guide you through each process and then show you how to reconcile the different results.
Market data (sales comparison) approach
The market data or sales comparison approach takes the economic concept of substitution and applies it to real estate. In real estate, the substitution principle essentially states that the value of a given property should be approximately the same as a similar or comparable property that provides the same benefits. This method is very much like what you may do yourself when purchasing a major item for your home — you compare similar items at various stores to assist you in determining what price to pay. Likewise, you don’t want to pay more for one property than a similar property would cost.
You’ve seen this concept at work in housing tracts in your area. When you see two similar homes built by the same builder at the same time on comparable lots, you expect them to sell for approximately the same price. (Of course, no two homes are identical, and adjustments in the price may need to be made for view, deferred maintenance, upgrades, terms of sale, and the specific supply and demand at the time of the proposed sale.)
The accuracy of the market data approach relies on a sufficient number of recent sales of comparable properties. This approach to valuation is primarily used for single-family homes, condos, and small apartment buildings because they’re typically more plentiful and offer data from many recent sales.
If there is a shortage of completed sales, an appraiser may look at current listings and pending sales, but they typically discount such potential transactions because they’re not finalized transactions, and many things can happen before the sale.
Typically, appraisers look for at least three comparable properties in close proximity to the subject property. Of course, the usage and type of real estate should be the same and a good comp is similar in age, size, features, amenities, and condition of the property. The timing of the sale is also important as well as the availability of seller financing.
Appraisers strive to find several comparable properties, but the reality is that every property is unique, and there are no truly identical sales or listings. So appraisers need to make either positive or negative adjustments to account for the differences. They then factor all of these variances into an adjustment to the price then calculate an indicated value for the subject property.
For example, you want to buy a duplex (that you can rent as an investment property) in your own neighborhood. You see one listed for $205,000 that is 2,500 square feet with two three-bedroom, two-bath units that are 1,250 square feet each. The property is about ten years old, in good condition, and has a great location on a corner lot. Using the market data approach, you contact a local broker and gather the recent sales data for comparable properties sold on the open market in your neighborhood. Table 12-2 contains the information you’ve collected for recent sales of duplexes in the same neighborhood.
Because each property is different, you need to make some adjustments to formulate a price for the proposed property. The adjustments are made for items or features that typical buyers and sellers in that area feel have a material impact on value either positively or negatively. For example, in the Phoenix area, a rental home with a swimming pool is more desirable than one without, and property condition and corner lots tend to be important in all markets.
After researching the local market to figure out what factors are important to buyers and sellers, you determine that adjustments should be made for the subject property based on its age, location on a corner lot, its condition, and the fact that it offers a swimming pool (see Table 12-3).
Property A is comparable in age to the subject property but is clearly inferior — it doesn’t have the corner lot or the swimming pool and is only in fair condition. The property sold ten months ago, and your research shows that prices for comparable properties in the neighborhood have risen 5 to 6 percent over the last year. So overall, you expect that if this property was being sold today in good condition, and had the corner lot and the swimming pool, it would’ve sold for approximately $30,000 more than the actual sale ten months ago, or an adjusted sales price of $200,000. You made adjustments for the corner lot ($5,000), condition ($5,000), the swimming pool ($15,000), and market timing ($5,000) for a total of $30,000 in adjustments to bring the property in line for comparison to the subject property.
Property B is a little older, but because it’s been well-maintained and is in good condition, no adjustment is necessary for that factor. It’s also on a corner lot and sold just last month, so no adjustments are necessary for these factors. However, it doesn’t have a swimming pool, which you have determined is worth at least $15,000 in value. With the swimming pool, this property would have likely sold now for $215,000.
Property C is brand new, has a swimming pool, and sold within the last two months. The only disadvantage when compared to your proposed investment is this property’s location in the middle of the block. Overall, your research indicates that the price difference for brand-new properties is $15,000 higher than a ten-year old property like the subject property. But comparable properties located in the middle of the block sell for $5,000 less. Therefore, you need to adjust the Property C price lower by $15,000 for age and higher by $5,000 for the inferior location, which is a net downward adjustment of $10,000 and leads you to an adjusted value of $210,000.
Table 12-3 Adjusting Sales Price to Determine Value
Proposed Property
Property A
Property B
Property C
Price
$205,000
$170,000
$200,000
$220,000
Adjustment
0
30,000
15,000
(10,000)
Value
$205,000
$200,000
$215,000
$210,000
After they’re established, your adjustments are made to the actual historical sales prices of the comparable properties to account for differences between the comparable properties and the subject property. The result of your work is a set of adjusted comparable sales prices representing estimates of what the comparable properties would have sold for had they possessed all of the important features or characteristics of the subject property. These adjusted sales prices become value indicators for the subject property.
When using the sales comparison approach, you only make adjustments to a comparable sale price as it relates to the subject property. When a feature or characteristic of a comparable property is inferior to that of the subject property, the adjustment to the comparable sale price is positive (you add the adjustment amount to the comparable sale price). When a feature or characteristic of a comparable property is superior to that of the subject property, the adjustment to the comparable sale price is negative (you subtract the adjustment amount from the comparable sale price). Our example uses lump-sum dollar adjustments; another acceptable method is to apply percentage adjustments. In reviewing the results of your analysis and adjustments in Table 12-3, you feel that the asking price is right in line with (if not slightly below) the current market price for comparable properties in the neighborhood. You decide that you have a good investment if you can purchase the property for $205,000 or less.
Cost approach
The cost approach to real estate valuation is a variation on the market data approach that’s useful when you don’t have a lot of comparable sales data. It’s more commonly used, and even the preferred method, for proposed construction, brand-new properties, and unique properties that typically don’t generate an income (including schools, hospitals, public buildings, or places of worship).
Real estate investors find that this method can be useful for establishing replacement cost. As we cover in Chapter 11, the replacement cost of a property can often be an indicator of barriers to entry that exist in the market. Owning superior location, well-maintained real estate in high demand with high barriers to entry for competing properties is one of the best ways to ensure the success of your real estate investments.
In determining valuation with the cost approach, evaluate each segment — the land and the improvements (buildings) — separately. Here are the steps an appraiser follows in applying the cost approach:
Estimate the value of the land if vacant and being used in its highest and best use (see Chapter 11).
The appraiser looks for sales of comparable vacant land in the area.
Estimate the current cost to reproduce the existing building as new, before depreciation.
Estimate all forms of accrued depreciation and deduct that amount from the calculation in Step 2 to arrive at the approximate cost to reproduce the building in its current condition.
Accrued depreciation can be caused by three sources:
Physical deterioration: Normal wear and tear that occurs from use over time. For example, a 12-year-old roof that can normally be expected to last 20 years. These conditions can almost always be corrected.
Functional obsolescence: Decline in the usefulness or desirability of a property due to changes in preferences by consumers. For example, a rental home with three bedrooms and only one bathroom. Functional obsolescence may be curable or incurable.
Economic or external obsolescence: Loss in value resulting from external forces. For example, the major employer in town closes down operations and the closest comparable jobs are in a city 25 miles away. You can’t control it, which means you need to understand and correctly assess it because it will change over time and can greatly impact the future success of your rental property.
Combine the value of the land and the value of the depreciated improvements to arrive at the total value of the property.
Using the duplex example from the previous section, you determine that the cost of a comparable vacant lot would be $40,000. Checking with local builders in your market indicates that the cost to build a new property would be $80 per square foot; however, because the building is ten years old, there is some wear and tear. You therefore estimate that the cost to rebuild the property in its current condition is $70 per square foot (this isn’t an exact science). The property is 2,500 square feet, so the total value of the depreciated improvements is $175,000.
Adding the land value of $40,000 to the $175,000 value for the depreciated improvements gives an overall value of the property of $215,000 under the cost method of valuation.
Income capitalization approach
This method of valuation is primarily used for larger income-producing properties but can be useful for small income properties as well. (It’s not used for valuing owner-occupied properties or properties whose primary purpose isn’t income producing.)
The income capitalization method is based on the principle that the greater the income generated, the more an investor is willing and able to pay for the property.
Our discussion of the income capitalization approach to valuation must start with the fundamental building block of determining value for this method — the direct capitalization or IRV formula. Here are the players in this formula:
Value (V): With this method, you’re looking to determine the value of a given property by examining the relationship between Net Operating Income (NOI) and the capitalization rate (R).
Net operating income (NOI): Yes, it’s back. Check out the “Figuring Net Operating Income” section earlier in this chapter to determine this piece of the puzzle.
Capitalization rate (R): Also called the cap rate and overall rate, this number is based on the market or the buyer’s objectives. It’s the rate of return most investors seek for similar properties in a similar market at a given time.
Put it all into equation form and you get
To illustrate, take the example of the proposed acquisition of a duplex in your neighborhood. The seller provides you with financial information on the property for the past two years and after a careful analysis, using the techniques discussed earlier in this chapter, you determine that the projected NOI for this property in the next 12 months is $19,500 per year.
Based on discussions with real estate brokers and your local county assessor, an analysis of recent comparable sales indicates that conventional sales of similar properties in the same area have sold for a cap rate of 10 percent.
Therefore, you calculate the as-is value of this property at $195,000.
The cap rate can be subjective, but it’s a measure of the risk-adjusted return a particular investor would expect to receive if he purchased a similar property at a similar price. Real estate brokers and agents often have information on current cap rates in the local market. You can actually derive the cap rate yourself by examining recent sales prices for similar properties as long as you have reliable info on the Net Operating Income. The formula is simply
You can use this formula to determine the capitalization rate or investment performance based on a given NOI and a purchase price. If the property were available for $190,000, what would the rate be?
You’ve increased your return by just over a quarter percent.
The direct capitalization method has some distinct advantages over the value benchmarks like the GRM or GIM (discussed in Chapter 11) because it includes operating expenses, but it still doesn’t objectively consider potential appreciation, financial leverage, or the risk of the investment. It should, but often data you receive from recent comparable sales may not include your analysis of economic or external obsolescence, which is very important because it’s out of your control. Each investor needs to consider these important variables or investment criteria and factor them into her cap rate calculations to determine the investment value of a given property. For example, properties with high appreciation potential, the ability to use positive leverage to increase overall return on invested capital, and low risk require a lower capitalization rate or expected rate of return.
Use future NOI projections in your income capitalization calculations because the historic numbers aren’t relevant to your potential ownership except for financing. However, most lenders are sophisticated and discount unusually positive financial results or give you the benefit of a pro forma income-and-expense projection when determining the terms of your loan.
A pro forma budget is one in which the budget for next year or a given period of time is projected based on an analysis of the current data available for the building. For example, the historic operating reports for a commercial office building don’t include the new lease with a major anchor tenant, but a pro forma operating budget does.
Reconciling the Three Results to Arrive at a Single Value
An appraiser takes the numbers derived from the market data approach, the cost approach, and the income capitalization approach and reconciles them to determine a single estimate of market value at a specific time. However, the appraiser doesn’t simply take an average of the three estimates of value, because all three methods may not be equally valid or reliable for the subject property.
Rather, the reconciliation process takes into consideration the relative merits of each approach, with more weight given to the most applicable approach. For appraisals of income-producing real estate, appraisers and real estate investors generally rely most heavily on the income capitalization approach because the property is being acquired as an investment.
In the proposed investment in the example duplex, you’ve determined the following values:
Market data: $205,000
Cost: $215,000
Income capitalization: $195,000
You’re pursuing this property as a real estate investment rather than an owner-occupied property, so give the most weight to the value suggested by the income capitalization method. The next most relevant valuation method is the market data approach, which indicates a value of $205,000. Consider the value indicated by the cost approach, but don’t give it that much emphasis — the building is existing and isn’t going to be rebuilt. Thus, by placing the most weight on the income capitalization indicated value of $195,000 and also factoring in the $205,000 from the market approach, you determine that $198,000 sounds about right for an offer.
You can then compare this value to the asking price for the property of $205,000. Although the seller may not be willing to accept an offer at $198,000, remember that you don’t become wealthy in real estate by paying full retail price for properties. You’re looking for a property that is available at a below-market price, such as a motivated seller may offer, or a property where you have the opportunity to add value.
Remember that the appraisal process isn’t an exact science, but the principles of valuation are important for real estate investors and the concepts should be understood. You want to be able to estimate value so you don’t overpay for a property. Your lender requires an appraisal to determine how much you can borrow. These same appraisal techniques can help you determine the appropriate asking price when you look to sell your real estate investment.
Putting It All Together: Deciding How Much to Pay
After you’ve done all of your research and calculations, the reality is that you still need to determine whether a proposed property is a good opportunity — and at what price? You don’t want to pay retail, but the typical properties you see are based on unrealistic representations by most sellers.
You want to buy when you project that the property has a strong likelihood of producing future increases in NOI and cash flow. So you should look for properties where your analysis shows that the income for the property can be increased or the expenses reduced.
In this chapter, we’ve covered NOI, cash flow, and the valuation techniques used by the professionals. Using those techniques can help you to determine the maximum price that you should pay for a property.
But sellers are also using similar techniques to set the maximum price they think they can squeeze out of the most generous buyer in the market. You need to understand how they may bend and twist the facts to present their property in the best light. The following examples demonstrate how being able to properly value investment real estate before making a purchase offer is essential.
Examining the seller’s rental rate and expense claims
Most sellers of investment properties claim that the rents are below market. Sellers may imply that instantly, and almost magically, upon purchasing the building the buyer will be able to enhance the value of her new investment property and improve her cash flow by merely (yet significantly) increasing rents.
Of course, you should be wondering: If I can make money by simply raising the rents, why doesn’t the current owner increase the rents and then sell the building at a much higher price? After all, sellers know that buyers will base their offer on NOI. The answer is that they usually do raise rents before putting the property on the market. But sellers (and their real estate agents) still go ahead and claim that the buyer can raise the rents even more. And if a buyer hasn’t done her homework and carefully evaluated the current rental market, she may well fall for the seller’s tricks.
The same scenario is found with expenses. The seller typically cuts back on spending to show artificially low expenses, or claims that the buyer can cut expenses through an energy conservation program or some other seemingly sensible method. This mindset assumes that the current owner hasn’t taken advantage of legitimate ways to cut down on expenses.
Of course, you can find exceptions where an owner has truly been too nice or lazy to keep the rents at market level or conduct an energy conversion to lower expenses. But we suggest that even if these claims are true, the buyer shouldn’t pay an inflated price based on the assumption of being able to make these changes because she’ll have to pony up to make the changes herself. Implementing these strategies to generate higher income and lower expenses also takes many months. For example, if you’ve ever given out a rent increase to full market value, you know that it’s generally unpleasant and often can result in unwanted turnover and higher vacancy and operating expenses for several months, and you should be compensated for your efforts — not the seller (who lacked the fortitude to implement the rent increase).
Deciding which set of numbers to use
When you look at listings of properties for sale, you find that many sellers and their brokers or agents develop a pro forma, or future estimate, of the NOI. From this artificially high NOI, they then derive an above-market asking price for the property. They also use the unrealistic pro forma NOI to show all of the various value indicators such as GRM and cap rate. In reality, the NOI would even drop if you were to unexpectedly lose some of your key tenants or be faced with a major unanticipated expense. So remember that this pro forma is an estimate of future operations of the property. The future is uncertain, so none of the numbers are truly right or wrong. And you’ll be amazed by how universally optimistic sellers are about how much more money you’ll make than they did when you buy their property!
Although the IRV formula uses the future NOI and the value of the building is determined based on those numbers, we suggest that you find a seller who calculated his asking price based on actual historical operating income and expenses. You want to anticipate the future and pay for the present. You need to set your offering price based on your own calculations as to the NOI you truly expect to earn in the year after your purchase. (For more on IRV, see the “Income capitalization approach” section earlier in this chapter.)
The other key component to the IRV formula is the capitalization rate. We demonstrate that if you lower the capitalization rate or required return, you can dramatically increase the value of the property. A lower rate of return is required when the risk associated with the cash flow of a property is lower. The risk is lower when the property is competitive with or superior to other comparable properties, has minimal deferred maintenance, and has solid tenants with leases in place that are at market. Your goal is to find properties that lack these characteristics, but you can easily achieve with superior management — either yourself or with a professional property manager.
Getting a return on your investment
Four elements determine the return you see on your investment:
Whether you receive current or projected NOI estimates from a seller, be careful to verify the numbers. Some sellers, and many real estate brokers and agents, prefer to provide a pro forma NOI (a projection of future financial performance of the property) that uses higher rents and lower expenses. These fictitious numbers are based on the hopeful theory that the new owner will raise the rents to market level and simultaneously lower the costs of operating the property. These assumptions are rarely valid. Unless the property has leases with built-in rent increases or that can be renewed at higher rates or below-market leases that are expiring while the demand is high, you seldom find a professionally managed property with below-market rents. If it were that easy to increase income, wouldn’t the current owner do it? Expenses are also unlikely to decrease significantly unless you have an older property where a lighting or HVAC retrofit will decrease energy usage.
If you have a single-family rental home, the property is either occupied or vacant. With the average length of residential tenancies in many parts of the country at less than one year, using a 0 percent vacancy factor is unrealistic. Our suggestion for your pro forma for a single-family rental home is to anticipate a loss of income equivalent to one month per every 12 months, which reflects an 8.3 percent vacancy rate. This rate may represent a vacancy, a delinquency, or a concession (see the following sections), but our experience indicates that, one way or another, you’re likely to lose at least one month’s rent/income on average per year, and you should allow for this prospect in preparing your pro forma to determine the potential income before making your investment decision.
