Alternative Investments - Real Estate Calculations

Cost Approach
Values real estate based on "what would it cost to replace the building in its current form with the value of the land added to it?" The cost approach sounds like a straightforward and easy-to-calculate method for determining value, but it is difficult to implement. Getting an apprised value for the cost of the existing structure can be difficult in some markets. Furthermore, the market value of the existing prosperity may be very different from its construction cost.

Sale Comparison Approach
This approach looks at the price at which other real estate property with similar characteristics (location, size, age, etc.) has recently been sold or valued. Most residential real estate is appraised or valued using this method. At times, this can also be a difficult method to implement: a comparable property may be hard to identify (especially if the property in question has unique features) or there may not be any sales of comparable properties in the recent past.

The Income Approach
This approach uses a perpetuity discount type of model. The net income derived from the property is discounted at a market required rate of return. The appraisal value = net operating income (NOI)/market cap rate. The Market cap rate is found by benchmark NOI/benchmark transaction price. The problem with this approach is that long-term tenants may not be paying current market rates, depressing the value of the investment. An inflationary environment may also take a bite out of the value of the property.

Discounted After-Tax Cash Flow Approach
Calculating the value of the discounted cash flows from a real estate investment can act as a validation or check on other valuation methods. This approach takes into account the investor's individual tax bracket, depreciation and any interest payments. See the example below.

Calculate Net Operating Income from a Real Estate Investment
The CFA Level 1 exam requires you to know how to create an income statement for a property. It goes as follows:


Potential Gross Income
Scheduled Rent $100,000
Escalation Income $10,000
Percentage Rent $10,000
Overage Rent $10,000
Market Rent $10,000
Other income $10,000
Total potential gross income $150,000
Vacancy and Collection loss(10%) ($15,000)
Effective Gross Income $135,000
Expenses
Fixed $5,000
Variable $5,000
Depreciation $5,000
Total Expenses $15,000
Net Income $120,000


Comparable Property: NOI $135,000, which sold for $750,000
NOI = $135,000 - $5,000 - $5,000 = $125,000
NOI/(Transaction Price): $135,000/$750,000 = 0.18
NOI/Cap Rate = $125,000/0.18 = $694,000= Which is the amount this property is being valued at.


Look Out!
Do not include financing cost or depreciation when calculating NOI.


Exam Tip
It would be very surprising if you have to compute all the types of rents and incomes because of the time constraints of the exam. However, candidates may be asked to calculate price increases of a certain time period to evaluate the impact on NOI.


Sales Comparison Approach:
Looks at the characteristics of similar properties and how they are valued:

Characteristic Units Value
Number of rooms Number $25,000
Number of bathrooms Number $10,000
Distance to city Miles ($2,000)


The property you want to value has eight rooms, three bathrooms and is 10 miles from the city.

The value would equal (8 * $25,000) + (3 * $10,000) +(10 * -$2,000) = $200,000 + $30,000 - $20,000 = $210,000 based on similar property types.

Income Approach:
In this approach, the investor would estimate total real estate value based on the rate of return from the property. Therefore, any potential rents expected from a lessee for use of the property would be compared against similar property types.


Calculating After-tax Cash Flows
Let's start with some basic information:

NOI = $125,000
Depreciation = $5,000
Mortgage payment = $60,000
Purchase price = $725,000
75% financing at 8% interest rate

NOI growth rate = 4%
Marginal Tax Rate = 31%.

After-tax cash flow = Amount borrowed ($725,000 * .75) = $543,750.
First year's interest = ($543,750* .08) = $43,500.
After-tax income = ($125,000 - $5,000-$43,500) * (1-.31)= $52,785

To arrive at after-tax cash flow from after tax income, depreciation must be added and the principal repayment of the mortgage payment must be subtracted.

The Stages in Venture Capital Investing
Related Articles
  1. Career Education & Resources

    How Hard are the CFA Exams?

    Learn about the difficulty of the CFA exams with a description of the tests, some statistics on pass rates and suggestions that can help you pass the exams.
  2. Professionals

    What it Takes to be a Financial Analyst

    A financial analyst researches companies and economic conditions to make business, sector and industry recommendations.
  3. Career Education & Resources

    Financial Analyst: Career Path & Qualifications

    Read about what it takes to become a financial analyst in a corporation or securities firm, and learn how far you can rise in the profession.
  4. Career Education & Resources

    Financial Planner: Career Path & Qualifications

    Learn what education and certifications you need to become a financial planner, as well as the future prospects and earnings potential for financial planners.
  5. Career Education & Resources

    Where to Find Non-Profit Finance Jobs

    The non-profit sector offers a stable selection of jobs for those who seek other types of fulfillment from their jobs than just purely financial.
  6. Career Education & Resources

    Portfolio Manager: Career Path & Qualifications

    Learn about the basic requirements for getting hired as a portfolio manager, and discover how most professionals in the field rise into the position.
  7. Your Practice

    4 Professional Associations Advisors Should Join

    These four professional organizations are among the most respected and well known in the industry.
  8. Professionals

    Equity Research: Career Path and Qualifications

    Find out what equity research analysts do on a day-to-day basis, and learn more about the typical career progression for these securities professionals.
  9. Professionals

    What's on the CFA Level II Exam?

    The Chartered Financial Analyst Level II exam is the second of three tests that CFA candidates must pass.
  10. Professionals

    Financial Data Analyst: Career Path & Qualifications

    Learn more about the career options available to financial data analysts, and determine whether the profession is a good match for you.
RELATED TERMS
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. CFA Institute

    Formerly known as the Association for Investment Management and ...
  3. Security Analyst

    A financial professional who studies various industries and companies, ...
  4. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
RELATED FAQS
  1. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
  2. How do I become a Chartered Financial Analyst (CFA)?

    According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
  3. What types of positions might a Chartered Financial Analyst (CFA) hold?

    The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
  4. Who benefits the most from prepaid expenses?

    Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
  5. If I am looking to get an Investment Banking job. What education do employers prefer? ...

    If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
  6. Can I still pass the CFA Level I if I do poorly in the ethics section?

    You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>
Hot Definitions
  1. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  2. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  3. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  4. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  5. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
Trading Center