by John Smith
Back at our February luncheon, we had a wonderful panel of bankers who spoke about financing real estate ventures. I wanted to take this opportunity to discuss more about some of the methods used by both bankers and investors to analyze and compare properties. While this may not be the most exciting facet of real estate, it is useful both to maximize your outcomes, and to be able to speak knowledgeably when you meet with your banker.
Methods of analyzing fall into two main categories: rules of thumb and discounted cash flow. Both have advantages and disadvantages.
Rule of thumb techniques are fairly quick calculations that can determine right away whether a property is feasible or not. They are easy to use and easy to learn. However, these techniques also have a number of limitations. They do not take much detail into account, and are, therefore, less accurate and less reliable.
The most basic technique used to analyze and compare properties is called the gross rent multiplier. The formula for this one is simple. Divide the rents generated in one year into the purchase price. In Champaign/Urbana, that usually results in a number between 5.5 and 7.5. In fact, at our lunch, Jan Miller with Bank Illinois observed that the gross rent multipliers have gradually been moving up. This means that the actual real estate prices have been increasing above and beyond what we would have historically projected when only looking at rents.
The gross rent multiplier is a quick and convenient way to look at a property and see if it falls into parameters that you have already established. It is also a very fast and easy way to compare the relative price of properties based on their rent producing power.
The shortcoming of the gross rent multiplier is that it doesn't take much information into account. Expenses are overlooked. Tax rates and tax consequences are ignored. While it is fast, it is also a very limited picture.
Another rule of thumb technique is called the capitalization rate or cap rate. A cap rate is another ratio to be looked at by investors to compare properties. The formula for the cap rate is the net operating income of the property divided by the purchase price. Now this formula takes more into account than gross rent multipliers, because the net operating income is the gross rents minus all of the anticipated expenses. This requires more detail than the gross rent multiplier, and so takes longer to calculate as well. This formula is particularly useful for discriminating between properties where the owner pays utilities, or where there is a need to address deferred maintenance.
If gross rent multipliers and cap rates are quick rules, then the discounted cash flow model is an entire guidebook. Those with a background in finance are already familiar with discounted cash flows. This was the method about which Anh To was speaking. To explain briefly, when you look at an investment property, you anticipate that it will produce future income in the form of rents. In fact, you will look at the property and try to predict as accurately as possible how much income will be generated. In this method, you will take into account all anticipated income, and then deduct all anticipated expenses. Taxes, utilities, maintenance, and long term items are calculated. For example, if you expect a roof to last twenty years, then you subtract one twentieth of the cost of a new roof every year in anticipation of the overall expense. Also, calculate the price that you believe the building will sell for at the end of your holding period.
Now, after figuring out future income to the best of your ability combined with your anticipated appreciation of the property, you have to decide how much that income stream is worth to you in the present. Future money is worth less than current money. Think of the difference between having ten dollars today, and having one dollar per year for the next ten years.
Finally, compare the value of that income stream to the asking price of the investment property. If it is selling for the same amount or less, you may well want to put the deal together. If it is selling for more, it may be best to walk away.
The advantages to the discounted cash flow model are that it gives a much fuller and more detailed picture of an investment. It also converts hunches and feelings into numbers with which bankers can be more comfortable. The disadvantages are that it takes a bit of practice and understanding to apply because there are many calculations involved. Very few people without a background in finance have used the discounted cash flow method.
Another shortcoming of the discounted cash flow approach is that it also takes into account what dollar value you expect the investment to appreciate to in the future. Without the aid of a crystal ball, or at least a magic eight ball, fortune telling can be risky business. Just ask anyone holding dot com stocks over the last six months.
John Smith has a Master's Degree in Education, is a real estate investment and management consultant and trainer throughout the state of Illinois, and has been a real estate investor and manager for over seven years in Champaign-Urbana. To contact John Smith, email him at email@example.com or call (518) 851-7820.