By Ian Woychuk, CFA
Real estate returns are generated in two ways. First, the income return comes from tenants' rent payments. The income return is a straightforward calculation because all you need to know is how much cash remains after all property expenses have been paid. The second type of return is the capital return, which is the increase or decrease in the value of the property due to changes in market demand and/or inflation. The capital return is more difficult to calculate, and requires the property to be valued or appraised. The resulting cash flows would be as follows:
If you want to determine the value of a real estate investment, the most accurate method is to sell the property and see how much money you get for it. Of course, the problem with this method is that you would no longer own that asset! In most cases you would want to determine the value without selling the asset, so you would approximate the value of the property based on the price that was actually achieved for other similar properties in the area of interest.
The approximation process can be inexact and subjective. The real estate market does not have the convenience of a public market, such as that for stocks, where you can continuously value an asset. Also, it is rare for two real estate properties to be exactly the same - unlike two shares of stock in a company, which are exactly the same. A third factor contributing to the subjectivity of real estate valuation is that it doesn't trade very often, so it can be difficult to establish a market value- especially if substantial time has passed since the last comparable trade.
All of the above noted valuation issues have given rise to a group of professional consultants referred to as appraisers. The task of an appraiser is to objectively assess the market value of a property by hypothesizing the most likely price of a trade between an arms-length buyer and seller. Appraisers have appropriate education and experience to perform property valuations, and typically are certified by a professional body which sets appraisal rules that must be followed by all of its members.
Appraisers use a variety of methods to determine value, and for income-producing properties the most common method is the capitalization rate approach. In its simplest form, a capitalization rate equals the net income from a property divided by its purchase price. To use the capitalization rate approach, an appraiser gathers capitalization rates from actual sales of similar properties, and based on those sales and capitalization rates forms a judgment on the appropriate capitalization rate for the property being valued. The appraiser then applies that capitalization rate to the subject property's income to estimate the value. For example, if the market-derived capitalization rate for a property is 10%, and the net income for that subject property is $100,000 in the year after you purchase the property, then the value of the property is $1,000,000.
Another often-used appraisal method is the discounted cash flow approach. This approach is somewhat more technical than the capitalization rate approach, but involves forecasting property cash flows over a fixed period then discounting the cash flows at a market-derived return to determine the current value. For example, assume that the cash flow from a property in Year 1 after the purchase is $100,000, and that the cash flow subsequently inflates by 5% per year. At the end of Year 5, assume the property is sold for $1,000,000.
The resulting cash flows would be as follows:
|--||Operating Cash Flows||Total Cash Flows|
If your required return on the purchase of the subject property with the above noted cash flows is 9%, then you would determine the net present value of the total cash flows using a discount rate of 9%. In this case, your value is roughly $1,075,000. If you lower your return expectations to 8%, then your property value would be closer to $1,120,000. In practice, an appraiser would be using market-derived discount rates, so he or she would use his best judgment on what the required return should be for the property being appraised.
If an appraiser is looking at a vacant building or land, they would use a third valuation method - the comparable sales approach. This approach assumes that if, for example, a vacant building sold for $100 per square foot, then the value of another similar vacant building would also be $100 per square foot. Land is also valued this way, with particular attention being paid to ensuring the benchmark land has equivalent zoning and density potential as the subject land.
Hiring an Appraiser
When choosing an appraiser to value your property, the most important consideration is that they have the appropriate experience and background to appraise your type of property. You don't want to hire a residential appraiser to value your commercial building unless they also have experience valuing commercial buildings. They also need to have experience appraising properties in your geographical area, because different locations have different market attributes. If your appraisal will be used by a third party, such as a mortgage lender, then you should be certain the lender will accept reports from your chosen appraiser. Last, the amount of the appraiser's fees should be a consideration.
The type and amount of mortgage financing is important to the performance of the property for two reasons. First, if your property has a closed mortgage in place that also happens to have poor terms (for example, a high interest rate or an undesirable loan to value or amortization period), then it can affect the value of the property. Therefore, it is important to consider the perception of the market when locking in your financing if there is a chance you will sell the property during the mortgage term.
The second reason financing is important is because of the ongoing effects of leverage. Although this topic is more fully covered in other mortgage related articles, it is worth briefly mentioning an example of how debt can influence your capital returns resulting from your appraisal.
Assume you purchased a property for $1,000,000 one year ago without any financing. You just completed an appraisal that says the property is worth $1,200,000. So, your capital gain is $200,000, which results in a capital return of 20%.
Now, assume you bought the same property but financed your purchase with a 50% loan to value, interest-only mortgage. After your purchase you therefore have $500,000 of your own cash invested and the bank has loaned you the other $500,000. One year later, you still owe the bank $500,000 because you used an interest-only mortgage. So when you get your $1,200,000 appraisal and subtract what you owe the bank, your equity in that property is worth $700,000. Since you have $500,000 invested, your capital gain is $200,000. Your capital return, however, is 40% rather than the 20% you would have achieved if you didn't use financing. This occurs because you still achieve a gain of $200,000, but you get it using only $500,000 of your own money instead of $1,000,000 of your own cash (but keep in mind that you would need to pay out interest payments to the bank). This is known as leverage, and it has a powerful impact on property returns.
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