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Lesson 3
Valuation Methods
Introduction
There are many different financial analysis tools
available to help determine what price an investor should pay for a given income
property and what kind of return they are likely to receive on their
investment. The more sophisticated the analysis and the longer the
projections into the future, the more assumptions that must be made and the more
likely that the predictions will be inaccurate. Therefore, it is usually more important to
determine the current value rather than guessing what it might be worth ten
years down the road. It is also best to utilize methods of analysis that
are adequate for the type and complexity of property being considered, but
not more complicated than necessary.
Before we get into the details of the most
reliable and useful methods for determining value, we want to give brief
descriptions of a number of methods that are sometimes used, some of which
provide meaningful results, some that do not. After surveying the
methods, we will look most closely at the three methods usually employed by
professional real estate appraisers. The various methods of valuation,
listed alphabetically, include:
- Cash-on-Cash Return
- Cash-on-Equity Return
- Cost Approach
- Debt Coverage Ratio
- Gross Rent Multiplier
- Income Approach
- Internal Rates of Return & Financial Market Rates of Return
- Market Data Approach
- Payback Rate
- Price Per Square Foot
- Price Per Unit
Cash-On-Cash Return
The cash-on-cash rate of return method uses
cash flow analysis to determine the value of property. It is calculated
using the following formula:
Cash-on-cash rate of return = Net
Operating Income less Debt Service divided by the amount of cash invested.
EXAMPLE
A property's Net Operating Income is $100,000, with a Debt Service of $60,000
and Operating Expenses of $25,000, giving a Cash Return of $15,000
The owner's Investment is $150,000
Cash-on-Cash rate of return = $15,000 divided by $150,000 = 0.10 or 10%
The amount used for the total cash invested
should include both the down payment and other funds necessary to make the
purchase (including financing costs). It should also take into account any
funds expended on deferred maintenance and capital improvements since purchase.
Cash-On-Equity Return
An analysis somewhat similar to
Cash-on-Cash and one that is useful after
a period of ownership, rather than in the beginning or when analyzing potential
purchases, considers the current equity rather than just the cash invested.
Thus, this "Return-on-Equity" method includes increase in value since
purchase.
EXAMPLE
We make the same assumptions as above except that the property's current value
is $50,000 more than its purchase price so that Equity = $150,000 + $50,000 =
$200,000 and
Return-on-Equity = $15,000 divided by $200,000 = 0.075 = 7.5%.
One should take into account the cost of sale
as well as any funds expended on deferred maintenance and capital improvements
since purchase.
Note that when increased value is included, the
rate of return is reduced. This is a major reason why many investors want
to "trade up" after properties have appreciated significantly.
Cost Approach
Also called Replacement Value approach, this
method determines the cost of buying the land and building an identical
structure as the subject property. The method takes into account current
land costs in the neighborhood and current construction costs in the local area.
The calculated value is reduced to take into account the age, condition, and
remaining useful life of the subject property.
Debt Coverage Ratio
The Debt Coverage Ration (DCR) is the ratio
between the annual Net Operating Income and the Annual Debt Service. A
property with a 1.2 Debt Coverage Ratio produces net income before debt service
that is 1.2 times as much as the debt service. The investment property
generates 20% more net income than it needs to make its mortgage payments.
Most lenders require a Debt Coverage Ratio of at
least 1.2 and some might require as high as 1.5 to finance an income property.
This ratio is intended to predict the ability to meet mortgage payments and the
level of risk to the lender. A
presentation to a lender should always include the anticipated Debt Coverage
Ratio, but if it doesn't, you can be sure that the lender will calculate it.
For that reason, we will cover this concept further when performing an example
analysis in a later lesson.
Gross Rent Multiplier
The simplest way to obtain rough estimates of the
value of a property-the so-called "yardstick value"-is to
calculate the gross rent multiplier (GRM). This method compares the property's
sale price with its current gross annual rental income to determine whether the
income will cover your new mortgage and operating expenses. The gross rent
multiplier is calculated using the following formula: GRM = Sale price divided
by the Gross annual rents. The higher the gross rent multiplier, the more
likely the property will yield a negative cash flow.
EXAMPLE
A property selling for $200,000 yields $16,700 in annual rent. The gross rent
multiplier is calculated as follows: GRM = $200,000 divided by $16,700 = 12
In other words, the property is selling for twelve times its annual rental.
You should
note that the gross rent multiplier does not take operating expenses into
consideration; this can sometimes result in over-valuation. For example,
buildings with common heat, electric or water have much higher expenses than
those in which tenants are responsible for their own utilities. The former
will dramatically lower net operating income compared to the latter, but the
gross rent multiplier would be identical if the sales prices and rents are the
same. Also, the multiplier does not take interest rates of loans into
account. Because of its severe limitations, GRM analysis should be used only
as a rough check against known values (sales prices) of comparable
properties.
Income Approach
Also called the Capitalization
approach, this method calculates value by "capitalizing" the net
operating income (NOI) of the property. The capitalization rate, or
"cap rate," is the yield that an investor expects to receive on his
investment, taking into account perceived risk and hassle compared to other
investment opportunities. Thus, Value = NOI divided by Cap Rate. The
cap rate varies considerably with both the type of property and current market
conditions. Different types of property in the same area at the same time
will have different cap rates because of differences in risk and management
needs. A cap rate of 8 percent may be considered desirable
for one type of property in one area at a particular time, whereas, for the same
type of property in the same area a year later a cap rate of 10 might be
appropriate. Note that going from a cap rate of 8 to 10 reduces the value
by 20 percent, assuming that the NOI remains unchanged.
EXAMPLE
A property has an estimated net operating income of $45,000 and the cap rate for
that type of property in that area is currently 10. $45,000 divided by
0.10 = $450,000. For a cap rate of 9 the value would calculate as $500,000
and for a cap rate of 11 the value would calculate as $409,999.
Obviously, since value is so highly dependent
upon the value used for the cap rate, investors must be certain to use the
correct number, both as to current market and as to type and size of property.
Equally important is the importance of using realistic NOIs. We will discuss how to determine the
appropriate cap rate as well as calculating NOI in later lessons.
Internal Rates of Return
Internal rate of return (IRR) and financial
market rate of return (FMRR) are sophisticated valuation methods used when
properties have uneven and/or negative cash flows. They usually factor in tax
ramifications and a sale of the property at some future date. The IRR uses
discounted cash analysis to measure investment yield. The FMRR is a modified IRR
that accounts for negative cash flows by using a safe estimated rate to save
funds and earn interest in profitable years. Investors should note that IRR and
FMRR are based on assumptions that may not be accurately predicted for real
estate investments.
Market Data Approach
Also called Comparative Market Analyses, this is
a method by which the value is determined by comparing the subject property to
similar properties that have recently sold, those that did not sell, and those
that are currently being offered for sale. This approach is the best indicator of value for owner
occupied housing and is also useful for small properties for which good
comparable properties are available.
Payback Rate
The Payback Rate is an old-fashioned, but widely
used yardstick for calculating the owner's return. It simply measures how
long it will take for an investor to earn back the investment. If the
investor purchased a building for $1,000,000 in cash, and the property delivered
an annual return of $100,000, at an 8% cost of funds, the payback period would
be just under ?? years.
Price Per Square Foot
Calculating price per square foot and price
per unit is a good way to evaluate a property against comparable buildings in
the area. Commercial buildings are usually leased at a annual square foot rate.
Price per
square foot is derived by dividing the building's cost by its square footage.
When using this method it is important to be sure that all calculations use the
same definition of area, whether that be gross, net, usable, rentable, or other
of the many definitions of area used in the real estate business.
The average cost per square foot of class A
apartments during the second quarter of 1997 was $77.59, up 10.6 percent over
1996 and 20.8 percent over the same period of 1995, according to Coldwell Banker
Commercial's National Sales Index.
Price Per Unit
Price per rentable unit is more commonly used on
residential rental properties. Price per unit is derived by dividing the sale
price by the number of units. This only has meaning if we are talking
about the same type of unit or on some specific mixture of types, as the cost of
units can vary substantially depending upon the number of bedrooms and baths.
For example a 3-bedroom/2-bath unit may be worth twice as much, or more, as a
studio/1-bath unit.
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