From a quantitative perspective, investing in real estate is somewhat like investing in stocks. To profit, investors must determine the value of the properties and make educated guesses about how much profit each will make, whether through property appreciation, rental income, or 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; integrating the gross income multiplier model in real estate is comparable to relative value valuations with stocks. Below, we'll take a look at how to value a real estate property using these methods.

The Capitalization Rate

One of the most important assumptions that a real estate investor makes when valuing properties is choosing an appropriate capitalization rate, which is the required rate of return on real estate net of value appreciation or depreciation. Put simply, it is the rate applied to net operating income to determine the present value of a property.

For example, if a property that is expected to generate net operating income (NOI) of $1 million over the next ten years is discounted at a capitalization rate of 14%, the market value of the property is $1,000,000 / .14 = $7,142,857 (net operating income/ overall capitalization rate = market value).

The $7,142,857 market value is a good deal if the property sells at $6.5 million. It is a bad deal if the sale price is $8 million.

Determining the capitalization rate is one of the key metrics in valuing an income-generating property. Although it is somewhat more complicated than calculating the weighted average cost of capital (WACC) of a firm, there are several methods that investors can use to find an appropriate capitalization rate. (For related reading, see "4 Ways to Value a Real Estate Rental Property")

The Build-Up Method

One common approach is the build-up method. Starting with the interest rate, add in:

  1. The appropriate liquidity premium (arises due to the illiquid nature of real estate)
  2. Recapture premium (accounts for net land appreciation)
  3. Risk premium (reveals the overall risk exposure of the real estate market)

Given an interest rate of 4%, a non-liquidity rate of 1.5%, a recapture premium of 1.5%. and a rate of risk of 2.5%, the capitalization rate of an equity property is summed as: 6+1.5+1.5+2.5 = 11.5%. If net operating income is $200,000, the market value of the property is $200,000/.115 = $1,739,130.

Obviously, performing this calculation is very straightforward. The complexity lies in assessing accurate estimates for the individual components of the capitalization rate, which can be challenging. The advantage of the build-up method is that it attempts to define and accurately measure individual components of a discount rate.

The Market-Extraction Method

The market-extraction method assumes that there is current, readily available net operating income and sale price information on comparable income-generating properties. The advantage of the market-extraction method is that the capitalization rate makes the direct income capitalization more meaningful.

Determining the capitalization rate is relatively simple. Assume an investor considers buying a parking lot expected to generate $500,000 in net operating income. In the area, there are three existing comparable income generating parking lot properties.

  • Parking Lot 1 has a net operating income of $250,000 and a sale price of $3 million. In this case, the capitalization rate is: $250,000/$3,000,000 = 8.33%.
  • Parking Lot 2 has a net operating income of $400,000 and a sale price of $3.95 million. The capitalization rate is: $400,000/$3,950,000 = 10.13%.
  • Parking Lot 3 has a net operating income of $185,000 and a sale price of $2 million. The capitalization rate is: $185,000/$2,000,000 = 9.25%.

Based on the calculated rates for these three comparable properties (8.33%, 10.13%, and 9.25%), an overall capitalization rate of 9.4% would be a reasonable representation of the market. Using this capitalization rate, an investor can determine the market value of the property. The value of the parking lot investment opportunity is $500,000/.094 = $5,319,149.

The Band-of-Investment Method

The capitalization rate is computed using individual rates of interest for properties that use both debt and equity financing. The advantage of the band-of-investment method is that it is the most appropriate capitalization rate for financed real estate investments.

The first step is to calculate a sinking fund factor. This is the percentage that must be set aside each period to have a certain amount at a future point in time. Assume that a property with net operating income of $950,000 is 50% financed, using debt at 7% interest to be amortized over 15 years. The rest is paid for with equity at a required rate of return of 10%. The sinking fund factor would be calculated as:

Interest Rate12 Months[1+(Interest Rate/12 Months)](# of Years12 Months)1\dfrac{\frac{Interest~Rate}{12~Months}}{{[1 + (Interest~Rate / 12~Months)]}^{(\#~of~Years * 12~Months)}-1}[1+(Interest Rate/12 Months)](# of Years12 Months)112 MonthsInterest Rate

Plugging in the numbers, we get:

{[1 + (.07/12)]15x12} – 1

This computes to .003154 per month. Per annum, this percentage is: .003154 x 12 months = 0.0378. The rate at which a lender must be paid equals this sinking fund factor plus the interest rate. In this example, this rate is: .07 + .0378 = 10.78%, or .1078. 

Thus, the weighted average rate, or the overall capitalization rate, using the 50% weight for debt and 50% weight for equity is: (.5 x .1078) + (.5 x .10) = 10.39%. As a result, the market value of the property is: $950,000/.1039 = $9,143,407.


How To Value A Real Estate Investment Property

Comparable Equity Valuations

Absolute valuation models determine the present value of future incoming cash flows to obtain the intrinsic value of a share; the most common methods are dividend discount models (DDM) and discounted cash flow (DCF) 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 to determine a range of possible values.

Calculating a Real Estate Property's Net Operating Income

Market Value=NOI1rg=NOI1Rwhere:NOI=Net operating incomer=Required rate of return on real estate assets g=Growth rate of NOIR=Capitalization rate (rg) \begin{aligned} &Market ~Value = \dfrac{NOI_1}{r-g}=\dfrac{NOI_1}{R}\\ &\textbf{where:}\\ &NOI = \text{\small Net operating income}\\ &r = \text{\small Required rate of return on real estate assets }\\ &g = \text{\small Growth rate of NOI}\\ &R = \text{\small Capitalization rate (r} - \text{\small g) }\\ \end{aligned}Market Value=rgNOI1=RNOI1where:NOI=Net operating incomer=Required rate of return on real estate assets g=Growth rate of NOIR=Capitalization rate (rg) 

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. Before deducting expenses, the total revenues gained from the investment must be determined. Expected rental revenue can initially be forecasted based on comparable properties nearby. With 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 earnings before interest, taxes, depreciation, and amortization (EBITDA).

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

Market Value = Gross Income ×Gross Income Multiplier\textit{\small Market Value = Gross Income }\times \textit{\small Gross Income Multiplier}Market Value = Gross Income ×Gross Income Multiplier

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 forecast to obtain an accurate gross income estimate.

For example, if a real estate investor purchases a 100,000-square-foot building, he may determine from comparable property data 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 x 12 months x 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 is $10.8 million ($12 MM x 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 is achieved if one has historical sales data. Looking at the sales prices of comparable properties and dividing that value by the generated gross annual income produces 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 earnings per share (EPS) figure by the P/E ratio of the industry. Real estate valuation can be conducted through similar measures.

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 and transparent 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 unique to this asset class. Some industry experts, for example, have an active working knowledge of city migration and development patterns. As a result, they can determine which local areas are most likely to experience the fastest rate of appreciation.

Whichever approach used, the most important predictor of a strategy's success is how well it is researched.