These are common approaches to analyzing real estate investments. The second group of approaches takes into account TVM (Time Value of Money).
- Sales Comparison Approach: Compares the subject property to similar properties recently sold, and calculates an average price per unit or square foot to determine value.
- Gross Rent Multiplier: A rough estimate of value. Generally used by investors that repeatedly buy the same types of property. Take your Sale Price and divide by Monthly Potential Gross Rental Income. This method determines the value of a property based solely on potential rental income for the first year. Limitations: It reflects a one year snapshot in time. It only helps to compare properties that have very similar operating expenses and have similar occupancy/vacancy rates.
- Direct Capitalization (Cap Rate): Take Net Operating Income (NOI) and divide by Sales Price. It is expressed as a percentage of the sales price offered, or a percentage of the price you are willing to pay. It accounts for operating expenses, gross rents, non rental income, vacancy and credit losses. Limitations: It is a one year snapshot. It does not account for the present versus the future value of the dollar (TVM, time value of money), nor does it account for owner financing, tax implications, property depreciation and appreciation.
- Cash on Cash: Looks at cash invested up front (not borrowed dollars), as related to the first year cash flow before taxes. Divide Before Tax Cash Flow (NOI less debt service and reserves) by the amount of cash invested for your down payment. This method accounts for the impact of owner financing (investing with borrowed money). It also accounts for operating expenses, gross rents, non rental income, vacancy and credit losses. Limitations: It is a one year snapshot. It does not account for TVM, nor does it take into account owner tax implications, or property depreciation and appreciation. When comparing properties in different areas, a property with a lower cash on cash return might be a better investment if the potential for appreciation is more predictable.
- Demographic/Trends Analysis: Projects potential appreciation and potential obsolescence by closely examining economic indicators, building and demographic trends (profiles of current and future buyers). Property appreciation will be driven by overall demand and scarcity in the market and impacted by obsolete property or community features. It is important to know how rare a property is in the market and how likely demand for this property is to increase or decrease due to competing existing properties and planned new construction. The Economic Trends Report is a valuable resource for this approach. This approach answers the question: Does this property have or can it have what buyers will be looking for in the future? Limitations: You must have reliable first-hand experience in a given market.
The following approaches take into account the time value of money (TVM) and the investor’s tax situation.
- IRR or Internal Rate of Return: Measures the average annual yield (percentage earned) on each dollar for as long as it remains in the real estate investment (entire holding period). It uses the initial amount invested, projected after tax cash flows, and projected after tax sales proceeds. Limitations: Reflects the return as long as the dollars stay in the investment and does not take into account reinvested returns. It measures an average annual return over time, so across multiple years it may exaggerate the impact of a single year with a very high return. This method can’t account for negative cash flows in future years nor can it account for the initial investment being phased in over time. It also does not account for returned dollars being reinvested as they are returned. You must make assumptions about future sales proceeds.
- Net Present Value of Discounted Cash Flows (NPV): Determines the dollar value of an initial investment by taking the sum of the present value of all future cash flows, netted against (or compared to) the initial cash investment. If NPV is high the investment exceeds investor expectations for a desired annual return. This approach uses after tax annual cash flow and after tax sales proceeds. Often used to compare different types of investments. Limitations: Does not account for money reinvested during a given holding period.
- Capital Accumulation: Takes into account return of and on investment in the circumstance where money returned is reinvested during the property’s entire holding period. Allows investors to compare two or more investment alternatives in terms of accumulated dollars rather than rate of return. Accounts for dollars that remain in investment and those that are returned from the investment and reinvested. Limitations: You must make assumptions about the potential sales price, as well as the potential returns of competing investments over time.