Choosing the correct approach to analyzing a real estate investment is as important as choosing the particular property or strategy. Selecting the wrong approach for a particular market or type of property could cause investors to forsake profits. Here is a summary of some different approaches used to assess value and returns.
Sale comparison approach: Compares the subject property to similar properties recently sold and calculates an average price per unit or square foot to determine value.
Gross rent multiplier: A rough estimate of value: take the sale price and divide by monthly potential gross rental income. Generally used by investors who repeatedly buy the same types of property. This method determines the value of a property based solely on potential rental income for the first year.
Limitations: It reflects a one-year snapshot in time. It only works when comparing properties that have similar operating expenses and similar occupancy/vacancy rates.
Direct capitalization (cap rate): Take the net operating income (NOI) and divide by sales price. It is expressed as a percentage of the sales price offered, or a percentage of the price an investor is willing to pay. It accounts for operating expenses, gross rents, non-rental income, vacancy and credit losses.
Limitations: It is a one-year snapshot. It does not account for the present versus the future value of the dollar (known as the time value of money, or TVM). It also does account for owner financing, tax implications, property depreciation and appreciation.
Cash on cash:
Looks at cash invested up front—not borrowed dollars—as related to the first year cash flow before taxes. Divide before tax cash flow (NOI less debt service and reserves) by the amount of cash invested for the down payment. This method accounts for the impact of owner financing (investing with borrowed money). It also accounts for operating expenses, gross rents, non-rental income, vacancy and credit losses.
Limitations: It is a one-year snapshot. It does not account for TVM, nor does it take into account owner tax implications, or property depreciation and appreciation. When comparing properties in different areas, investors might consider a property with a lower cash on cash return, because it might be a better investment if the potential for appreciation is more predictable.
Demographic/trends analysis: Projects potential appreciation and potential obsolescence by closely examining economic indicators, building and demographic trends (profiles of current and future buyers). Property appreciation will be driven by overall demand in the market and impacted by obsolete property or community features. It is important to know how rare a property is in the market, and how likely demand for this property is to increase or decrease because of competing existing properties and planned new construction. The Economic Trends Report is a valuable resource for investors using this approach. This approach helps investors answer the question: Does this property have, or can it have, what buyers will be looking for in the future?
Limitations: To use this approach, investors must have reliable first-hand experience in a given market.
The following approaches take into account TVM, the investor’s tax situation and mortgage debt service.
Internal rate of return (IRR): Measures the average annual yield (percentage earned) on each dollar for as long as it remains in the real estate investment (entire holding period). It uses the initial amount invested, projected after tax cash flows, and projected after tax sales proceeds.
Limitations: Reflects the return as long as the dollars stay in the investment and does not take into account reinvested returns. It measures an average annual return over time, so across multiple years it may exaggerate the impact of a single year with a high return. It cannot account for negative cash flows in future years, nor can it account for the initial investment being phased in over time. Investors must also make assumptions about future sales proceeds.
Net present value of discounted cash flows (NPV): Determines the dollar value of an initial investment by taking the sum of the present value of all future cash flows netted against (or compared to) the initial cash investment. If NPV is high, the investment exceeds investor expectations for a desired annual return. This approach uses after tax annual cash flow and after tax sales proceeds. This approach is often used to compare different types of investments, such as stocks and CDs versus real estate.
Limitations: This approach does not account for money reinvested during a given holding period.
Capital accumulation: Takes into account return of and on investment in the circumstance where money returned is reinvested during the property’s entire holding period. This method allows investors to compare two or more investment alternatives in terms of accumulated dollars rather than rate of return. It accounts for dollars that remain in the investment and those that are returned from the investment and reinvested.
Limitations: Investors must make assumptions about the potential sales price as well as the potential returns of competing investments over time.