REAL ESTATE INVESTMENT ANALYSIS

Chapter 4: Real Estate Property Analysis

How To Value A Real Estate Investment Property

From a quantitative perspective, investing in real estate is somewhat like investing in stocks. In
order to profit in real estate investments, investors must determine the value of the properties
they buy and make educated guesses about how much profit these investments will generate,
whether through property appreciation, rental income or a combination of both.

Equity valuation is typically conducted through two basic methodologies: absolute value and
relative value. The same is true for property assessment. Discounting future net operating
income (NOI) by the appropriate discount rate for real estate is similar to discounted cash
flow (DCF) valuations for stock, while integrating the gross income multiplier model in real
estate is comparable to relative value valuations with stocks. Here we'll take a look at how to
valuate a real estate property using these methods.

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Comparable Equity Valuations

Absolute valuations models determine the present value of future incoming cash flows in order
to obtain the intrinsic value of a share; the most common methods are dividend discount models
and discounted cash flow techniques. On the other hand, relative value methods suggest that
two comparable securities should be similarly priced according to their earnings. Ratios such as
price-to-earnings and price-to-sales are compared to other intra-industry companies to
determine whether a stock is under or over-valued. As in equity valuation, real estate valuation
analysis should implement both procedures in order to determine a range of possible values.

Calculating a Real Estate Property's Net Operating Income

Where:

NOI - net operating income

r- Required rate of return on real estate assets
g- Growth rate of NOI
R- Capitalization rate (r-g)

The net operating income reflects the earnings that the property will generate after factoring in
operating expenses but before the deduction of taxes and interest payments. Prior to deducting
expenses, the total revenue gained from the investment must be determined. Expected rental
revenue can initially be forecasted based on comparable properties in the area. By doing the
proper market research, an investor can determine what prices tenants are being charged in the
area and assume that similar per-square-foot rents can be applied to this property. Forecasted
increases in rents are accounted for in the growth rate within the formula.

Since high vacancy rates are a potential threat to real estate investment returns, either
a sensitivity analysis or realistic conservative estimates should be used to determine the
forgone income if the asset is not utilized at full capacity.

Operating expenses include those that are directly incurred through the day-to-day operations of
the building such as (property insurance, management fees, maintenance fees and utility costs).
Note that depreciation is not included in the total expense calculation. The net operating income
of a real estate property is similar to the EBITDA of a corporation.

Determining the appropriate discount rate is somewhat more complicated than calculating
the WACC of a firm. Although there are different ways to obtain the capitalization rate, a
common approach is the build-up method. Starting with the interest rate, add the
appropriate liquidity premium, recapture premium and risk premium. The liquidity premium
arises due to the illiquid nature of real estate, the recapture premium accounts for net land
appreciation, while the risk premium reveals the overall risk exposure of the real estate market.
Discounting the net operating income from a real estate investment by the market capitalization
rate is analogous to discounting a future dividend stream by the appropriate required rate of
return, adjusted for dividend growth. Equity investors familiar with dividend growth models
should immediately see the resemblance. (The DDM is one of the most foundational of financial
theories, but it's only as good as its assumptions. Check out Digging Into The Dividend Discount
Model.)

Finding a Property's Income-Generating Capacity

The gross income multiplier approach is a relative valuation method that is based on the
underlying assumption that properties in the same area will be valued proportionally to the gross
income that they help generate. As the name implies, gross income is the total income before
the deduction of any operating expenses. However, vacancy rates must be forecasted in order
to obtain an accurate gross income estimate.

For example, if a real estate investor purchases a 100,000 square foot building, based on
comparable property data he may determine that the average gross monthly income per square
foot in the neighborhood is RM10. Although the investor may initially assume that the gross
annual income is RM12 million (RM10*12 months*100,000 sq. feet), there are likely to be some
vacant units in the building at any given time. Assuming that there is a 10% vacancy rate, the
gross annual income would be RM10.8 million (RM12m *90%). A similar approach is applied to
the net operating income approach as well.

The next step in assessing the value of the real estate property is to determine the gross
income multiplier. This can be achieved if one has access to historical sales data. Looking at the
sales price of comparable properties and dividing that value by the gross annual income that
they generated will produce the average multiplier for the region.

This type of valuation approach is similar to using comparable transactions or multiples to value
a stock. Many analysts will forecast the earnings of a company and multiply the EPS figure by
the P/E ratio of the industry. Real estate valuation can be conducted through similar measures.
(Learn how to put one of the top equity analysis tools to work for you. Check out Peer
Comparison Uncovers Undervalued Stocks.)

Roadblocks to Real Estate Valuation

Both of these real estate valuation methods seem relatively simple. However, in practice,
determining the value of an income-generating property using these calculations is fairly
complicated. First of all, obtaining the required information regarding all of the formula inputs
such as net operating income, the premiums included in the capitalization rate and comparable
sales data may prove to be extremely time consuming and challenging. Secondly, these
valuation models do not properly factor in possible major changes in the real estate market such
as a credit crisis or real estate boom. As a result, further analysis must be conducted to
forecast and factor in the possible impact of changing economic variables.

Because the property markets are less liquid than the stock market, sometimes it is difficult to
obtain the necessary information to make a fully informed investment decision. That said, due to
the large capital investment typically required to purchase a large development, this complicated
analysis can produce a large payoff if it leads to the discovery of an undervalued property
(similar to equity investing). Thus, taking the time to research the required inputs is well worth
the time and energy.

The Bottom Line

Real estate valuation is often based on similar strategies to equity analysis. Other methods, in
addition to the discounted net operating income and gross income multiplier approach, are also
frequently used. Some industry experts, for example, have an active working knowledge of city
migration and development patterns. As a result, they are able to determine which local areas
are most likely to experience the fastest rate of appreciation. Whichever approach one decides
to use, the most important indicator of its success is how well it is researched. (Learn how to
filter out the noise of the market place in order to find a solid way of determine a company's
value.
Real estate appraisal, property valuation or land valuation is the process of valuing real
property (usually market value). Real estate transactions require appraisals because they occur
infrequently and every property is unique (especially their location, a key factor in valuation),
unlike corporate stocks, which are traded daily and are identical (thus a centralized Walrasian
auction like a stock exchange is unrealistic). Appraiser reports form the basis
for mortgage loans, settling estates and divorces, taxation, and so on. Sometimes the report is
used by both parties to set the sale price of a property.

Most, but not all, countries require appraisers to be licensed or certified. Appraisers are often
known as "property valuers" or "land valuers"; in British English they are "valuation surveyors". If
the appraiser's opinion is based on market value, then it must also be based on the highest and
best use of the real property. For mortgage valuations of improved U.S. residential properties,
appraisals are generally reported on a standardized form like the Uniform Residential Appraisal
Report.[1] Appraisals of more complex properties (e.g., income-producing, raw land) usually
include a narrative appraisal report.

Types of value

There are several types and definitions of value sought by a real estate appraisal. Some of the
most common are:

 Market value – The price at which an asset would trade in a competitive Walrasian
auction setting. Market value is usually interchangeable with open market value or fair
value. International Valuation Standards (IVS) define:

Market value – the estimated amount for which an asset or liability should exchange on
the valuation date between a willing buyer and a willing seller in an arm's length
transaction, after proper marketing and where the parties had each acted knowledgeably,
prudently and without compulsion.
Value-in-use, or use value– The net present value (NPV) of a cash flow that an asset
generates for a specific owner under a specific use. Value-in-use is the value to one
particular user, and may be above or below the market value of a property.

 Investment value – is the value to one particular investor, and may or may not be
higher than the market value of a property. Differences between the investment value of an
asset and its market value provide the motivation for buyers or sellers to enter the
marketplace. International Valuation Standards (IVS) define:

Investment value – the value of an asset to the owner or a prospective owner for
individual investment or operational objectives.
 Insurable value – is the value of real property covered by an insurance policy. Generally it
does not include the site value.
 Liquidation value – may be analyzed as either a forced liquidation or an orderly
liquidation and is a commonly sought standard of value in bankruptcy proceedings. It
assumes a seller who is compelled to sell after an exposure period which is less than the
market-normal time-frame.

Approaches to Property Analysis

There are 3 approaches to valuing property

 Market comparison approach (comparing a property's characteristics with those of

comparable properties that have recently sold in similar transactions).
 Cost approach (the buyer will not pay more for a property than it would cost to build an
equivalent).

 Income approach (similar to the methods used for financial valuation, securities analysis
or bond pricing).