Evaluating Investment Real Estate
As an investor in Real Estate, it is important to be proficient in the process of evaluating investment Real Estate that you are interested in. Once you have established your criteria for investment property to qualify to be added to your portfolio, it becomes a far less subjective process. The type of property you choose (retail, office, industrial, multi-family, development land etc.) will most likely be the result of your personal "bent". Some investors just love retail property investments and others just love apartments. It is important that you have an affinity for the type of property you invest in.
There are three primary approaches to evaluating investment property:
The Cost Approach
This approach is based on the premise that the property's value is equal to the current value of the underlying land plus the cost to re-produce the existing improvements less depreciation for the age of the improvements. The Cost Approach is most effective when evaluating a newer building that is subject to less depreciation factor for age and is a very effective approach to use when needing to determine whether to buy an existing property or develop a new property. For evaluating investment property, this approach does not address the return on investment to the investor.
The Comparative Approach
This approach is based on the premise that the property's value is determined by the price that similar properties have sold for adjusted for time of sale, location and condition. The values being compared can be whole property values, price per square foot, price per acre etc. It would seem, on the face of it, that this approach is the most efficient method of determining value and in fact is the most commonly used approach in evaluation Residential property. Like the Cost Approach, the Comparative Approach does not address the return on investment to the investor.
The Income Approach
This approach is based on the premise that the value of the property is determined by it's ability to earn income for the investor. The higher the Net Operating Income , the higher the value. Net Operating Income or NOI is the Gross Annual Operating income less the Annual Operating Expenses like Property Taxes, Insurance, Utilities and Repairs & Maintenance etc. The function of converting the Net Operating Income of the property to the property value is called Capitalization. The Capitalization Rate (or Cap Rate) is the expression of the annual NOI relative to the value of the property expressed as a percentage.
Example:
Value of the Property $100,000
Gross Annual Operating Income $ 40,000
Less Annual Operating Expenses $ 30,000
Net Operating Income (NOI) $ 10,000 or 10% of the property value = 10% Cap Rate
Many Investors use the reverse of the above calculation to determine what they are willing to pay for a property. The Investor may determine that he/she requires a 10% return on investment or 10 CAP. If the NOI is $50,000 the indicated value of the property is $500,000. ($50,000 X 10% or $50,000 X 100/10 = $500,000). This approach assumes the property is purchased for all cash.
The Correlation
This is an Appraisal term for essentially boiling down the results of the three approaches to value and arriving at an estimate of Fair Market Value.
In the case of Investors using the reverse calculation to determine a property value based on his/her desired CAP rate, they contribute to establishing market values as their desired CAP Rates usually reflect comparative return rates available in other investments, desirability of the property in it's location and over-all competition for Investment Capital.
A Commercial Realtor can assist you in working through the numbers to determine if a property has an adequate Return On Investment (ROI) to suit your needs.
