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 $10. Although the investor may initially assume that the gross annual income is $12 million ($10*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 $10.8 million ($12m *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. See Equity Valuation In Good Times And Bad.)

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