VALUATION METHODS USED IN REAL ESTATE INVESTING – CAPITALIZATION RATE & MORE
As an investor one of the most important processes involved in making an investment decision is the Due Diligence period. During this time it is important to gather as much information as possible about the investment in order to evaluate multiple investments efficiently. The easiest way to understand the financials of a potential investment is by determining the property’s value using one of the standard valuation methods used in real estate investing.
An easy ‘snapshot’ of a property’s financial viability can be calculated by determining its capitalization rate, or cap rate. Cap rate clearly indicates a property’s un-leveraged rate of return and is a useful metric in determining one’s expected return on investment, prior to factoring in mortgage financing.
Valuation Methods Used in Real Estate Investing – Cap Rate Defined
Cap rate is the Net Operating Income (NOI) of a property divided by its purchase price – it is a percentage of expected return.
Net Operating Income is calculated by subtracting acquisition costs, utilities costs, property taxes, insurance, management costs and all other operating costs from the gross revenue.
NOI does NOT take into account the cost of financing even though it is one of the most common valuation methods used in real estate investing.
Generally a lower cap rate implies lower risk, while a higher cap rate implies increased risk.
Cap rates are helpful for evaluating the following property types:
Commercial Real Estate
Multi-family Real Estate
If financing, keep in mind that a better metric used in determining the value or viability of a financed investment is the cash on cash return, which is calculated by reducing the cash flow by any debt service. Cash on cash return can also be determined by dividing the mortgage payments by the amount of cash invested.
When Cap Rate is NOT a Good Method of Valuation
Although cap rate is a great way to value rental properties, in other instances it is not advisable to use cap rate as a method of valuation. This is true for fix and flips, short-term rentals and raw land. Because cap rate calculations include NOI, there would be no income therefore you could not determine cap rate and would need to use one of the three other valuation methods used in real estate investing.
Understanding Cap Rates
Cap rates are useful in determining the profitability of commercial properties and multi-family real estate however it is not the most useful tool when evaluating single-family residential properties. For these properties comparables, or comps, would be the most appropriate means of determining its market value. Residential homes are valued by what other similar properties sold for nearby, while investment properties are valued based on their profitability.
Every city and neighborhood is different. It does not make sense to compare similar cap rates in California to those in New Jersey, simply because local markets vary significantly.
Cap rates are essentially an estimated rate of return. For example, a $1,000,000 all-cash purchase with a cap rate of 5% will produce a $50,000 net profit before debt servicing.
What is a Good Cap Rate?
A good cap rate is determined by your goals – what you may consider a good cap rate may not be good for another investor if you have a difference in intended outcomes. To determine what a good cap rate is for you, you must consider whether it is more important to earn a higher monthly income OR realize long-term appreciation. If you’re lucky and with some experience under your belt you can occasionally achieve both.
If you are seeking a higher monthly income with less appreciation long term, an investment in low income housing could be advantageous. Low income neighborhoods tend to have lower expenses, higher monthly cash flows but not much appreciation over time, resulting in higher than average cap rates. Similar income and expense ratios can be found in Opportunity Zones.
>>>If you’re unsure of where to invest, check out our blog “6 Best Practices for Investing in Real Estate”
Cap rates in Tier 1 cities tend to be much lower. The expenses and costs associated with maintaining a property in a good neighborhood can be excessive, especially property taxes, HOA fees, and property management expenses. A good example of this is New York City where there will be far less cash flow on a monthly basis however the property will appreciate over the long term.
Cap Rate Comparison
The most useful application of cap rate is using it to compare to other investments. By comparing cap rates between investments you will train your gut on what the instinctual differences are that separate the great deals from the mediocre ones. Comparing cap rates is one of the most telling valuation methods used in real estate investing.
High cap rates are found in low-income areas with the highest crime rates, where most properties are Class C or D with poor schools and outdated construction. Cap rates in these neighborhoods tend to be higher, however there are little to no amenities and the school systems may be struggling.
A medium cap rate of about 5.5% – 8% is common in many suburbs and blue collar neighborhoods. Class B and C properties are abundant, the school systems and the amenities are average. The crime rate in these neighborhoods is slightly higher, but not significantly so.
A low cap rate (3.5%-5%) is found in better locations, where amenities may be abundant, the crime rates are low, the schools are typically some of the best in the country and the housing inventory mostly comprises of newer construction and Class A properties.
When comparing cap rates it is important to compare the exact same costs per property. It is invalid to compare the cap rate of a property that accounts for annual vacancies with a cap rate that makes no such discounts. The best valuation methods used in real estate investing take into account the same expenses and discounts.
Other Terms to Know Relative to Cap Rate & Investments: Cap Rate Compression
Cap rates can be influenced and are not a fixed ratio. Cap rate compression is the economic, geographical and market conditions that could push cap rate lower; a clear example of cap rate compression would be increasing prices in the market causing a perception of lower risk for that asset class. If cap rates are compressing it simply means that the market is heating up. Check out historical cap rates in that area to provide insight into the direction of property values.
As an investor you have the opportunity to purchase a higher cap rate, renovate and either refinance-and-hold or sell once the upgrades are completed. By following current market conditions you’ll be able to determine the best exit strategy for the long-term. A renovated property would command higher rents and increased expenses, resulting in an increase in NOI and property value thereby decreasing the property’s cap rate.
Reversion Cap Rate
Also known as exit cap, this is the projected cap rate when the investment is due to be sold. It is calculated by dividing the expected net operating income (NOI) by the expected sale price and is expressed as a percentage. Smart investors should look for both falling cap rates and rising NOI in order to maximize the resale price and expected capital gains.
Although reversion cap rate is not one of the more common valuation methods used in real estate investing, it will help guide an investor’s preparation for an eventual sale.
The 4 Most Common Methods of Investment Property Valuation
As an investor evaluating real property for cash flow purposes, there are four common ways to determine the market value of real property: Capitalization of Income (which we explored in depth), Comparable Sales, Discounted Cash Flow Analysis and Replacement Cost.
Capitalization of Income
The capitalization of income (or cap rate) values an investment property based on the expectation of future income. As an investor, this valuation method is preferred. This method relates the property’s value to the market rent that can be expected. One MUST have a clear picture of a property’s Net Operating Income in order to properly determine the cap rate for an investment property.
The comparable sales approach compares a specific property to other similar properties with the same characteristics that have recently sold. This method takes into account all the specifics of the property, for example its size, the lot size, the number of bedrooms and bathrooms, and any amenities or features that influence the overall property value.
Looking at these comparables side by side allows an investor to get a real-time temperature of the local market – from average cost per square foot to typical amenities one can expect of a property in that area. The more local knowledge you have of a particular market the better as it will provide leverage for your future negotiations.
The replacement cost method determines the current cost of constructing a similar property, using the same construction materials and adhering to the same (or similar) floor plan/layout and design standards.
Replacement cost is often used as a way to measure whether an asset is over or undervalued. The actual replacement cost of a property is what it would cost to rebuild the property – and the cost of putting a tenant in that property. If a property’s current market value is below its current replacement cost, that’s generally a sign that the property is not overvalued.
Discounted Cash Flow Analysis
Discounted Cash Flow Analysis is a valuation method used to estimate the value of an investment based on its future cash flow. This analysis attempts to figure out the value of an investment today based on projections of how much money it will generate in the future. This method can also be used to determine the cap rate for properties with inconsistent cash flow.
DCF—Discounted cash flow, which is the sum of all future discounted cash flows that an investment is expected to produce
CF—Cash flow for a given year
r—Discount rate, or the target rate of return on the investment expressed in decimal form
A discounted cash flow model (“DCF model”) is a type of financial model that values a company by forecasting its’ cash flows and discounting the cash flows to arrive at a current, present value. The DCF has the distinction of being both widely used in academia and in practice. Valuing companies using the DCF is considered a core skill for investment bankers, private equity, equity research and “buy side” investors.
DCF does not take into account any market-related valuation information, such as the valuations of comparable companies, and should generally only be done alongside other valuation techniques. Regardless of which valuation method you utilize, always make sure to double check your data for accuracy as bad data will produce a bad valuation.
Wrapping Up – Valuation Methods Used in Real Estate Investing
It is necessary to keep in mind that an estimate of a property’s value must take into consideration economic and social trends, as well as governmental controls or regulations and environmental conditions that may influence the four elements of value: demand, scarcity, utility and transferability.
Given the current volatile economic environment it is more important than ever for smart investors to really understand the benefits and risks of using cap rates to determine which investment opportunities are worth pursuing and which are overpriced compared to similar investments on the market.
If you’re an investor, leave a comment below about your experience using cap rate, or any other valuation methods used in real estate investing that you have found helpful. We look forward to hearing from you!
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