How To Evaluate Investment Property

Investors use different approaches when evaluating an investment opportunity. The following are commonly used ratios and quotients used to determine if the property is right for their investment purposes.

Capitalization Rate (Cap Rate)

The Capitalization Rate or Cap Rate is a ratio used to estimate the value of income-producing properties. Put simply, it is the net operating income divided by the sales price or value of a property expressed as a percentage. It is one of many financial tools used by investors, lenders, and appraisers to establish a reasonable purchase price for a given investment property in a specific market.

Cap rates may vary in different areas of a city for many reasons such as the desirability of location, level of crime, and general condition of an area. Investors expect larger returns when investing in high-risk income properties.

In a real estate market where net operating incomes are increasing and cap rates are declining over time for a given type of investment property such as office buildings, values will be generally increasing. If cap rates are increasing over time and net operating incomes are decreasing for residential income property in a particular market place, residential income property values will be declining.

If you would like to find out what the cap rate is for a particular type of property in a given market, check with an appraiser or lender in that area. Since the frequency of sales for commercial income properties in a given market place may be low, reliable cap rate data may not be available.

If you are able to obtain cap rate data from an appraiser or lender for the type of property you are evaluating, check to see if the cap rate value was determined with recent sales of comparable properties or if it was constructed.

When adequate financial data is unavailable, appraisers may construct a cap rate through analysis of its component parts thus reducing the credibility of the results. Cap rates which are determined by evaluating the recent actions of buyers and sellers in a particular market place will produce the best market value estimate for a property.

If you are able to obtain reliable cap rate data, you can then use this information to estimate what similar income properties should sell for. This will help you to gauge whether or not the asking price for a particular piece of property is over or underpriced.

Example 1: A property has a NOI of $155,000 and the asking price is $1,200,000

$155,000
Cap Rate =______ X 100 = 12.9 rounded
$1,200,000

Example 2: A property has an NOI of $120,000 and Cap Rates in the area for this type of property are 12%

$120,000
Estimated Market Value = ______ = $1,000,000
.12

Net operating income is equal to gross income minus the vacancy amount and operating expenses. Operating expenses include such items as advertising, insurance, maintenance, property taxes, property management, repairs, supplies, and utilities and do not include depreciation, interest, and amortization. Appraisers use the Income Approach, Cost Replacement, and Market Comparison methods to estimate the value of a property. The Income Approach utilizes the theory of Capitalization.

Cash On Cash Return (CCR)

Cash on Cash Return is a percentage that measures the return on cash invested in an income producing property. It is calculated by dividing before-tax cash flow by the amount of cash invested and is expressed as a percentage. If before-tax cash flow for an investment property is equal to $15,000 and our cash invested in the property is $100,000, cash on cash return is equal to 15%.

Before-Tax Cash Flow: $15,000
CCR = ______ X 100 = -______ X 100 = 15%
Cash Invested: $100,000

The following shows how before-tax cash flow is derived

Gross Income: 54,500
Less Vacancy Amount: 2,500
Gross Operating Income: 52,000
Less Operating Expenses: 17,000
Net Operating Income: 35,000
Less Annual Debt Service: 20,000
Before-Tax Cash Flow:15,000

Cash on Cash Return is used to evaluate the profitability of income-producing properties. It can be useful when comparing investment properties but is just one of many analysis tools. It only considers before-tax cash flow and doesn’t take into account an investor’s individual income tax situation and it doesn’t consider the wealth-building potential of a property via appreciation.

A property in one area of a city may have a better Cash on Cash Return then a property in another location, but it may not appreciate as fast because of it’s location. One location may be more desirable than the other.

Debt Service Coverage Ratio (DSCR or DCR)

Also known as Debt Service Coverage Ratio (DSCR). The debt coverage ratio is a widely used benchmark which measures an income producing property’s ability to cover the monthly mortgage payments.

The DCR is calculated by dividing the net operating income (NOI) by the annual debt service. Annual debt service is equal to the annual total of all interest and principal paid for all loans on a property. A debt coverage ratio of less than 1 indicates that there is inadequate cash flow generated by an income property to cover the mortgage payments. For example, a DCR of .9 indicates a negative cash flow.

There is only enough income available to pay 90% of the annual mortgage payments or debt service. A property with a DCR of 1.25 generates 1.25 times as much annual income as the annual debt service on the property. In this example, the property creates 25% more income than is required to cover the annual debt service.

Example: We are considering buying an investment property with a net operating income of $24,000 and annual debt service of $20,000. The DCR for this property would be equal to 1.2. This means that it generates 20% more annual income than is required to cover the annual mortgage payment amount.

Net Operating Income: $24,000
DCR = ______ = ______ = 1.2
Annual Debt Service: $20,000

Many lending institutions require a minimum debt coverage ratio value to procure a loan for income producing properties. DCR requirements for lending institutions may vary from as low as 1.1 to as high as 1.35. From a lending institutions perspective, the higher the DCR value, the more income there is available to cover the debt service and thus the less the risk.

Income
Gross Rents Possible: 35,000
Other Income: 2,000
Total Gross Income: 37,000
Less Vacancy Amount: 3,000
Gross Operating Income: 34,000
Less Operating Expenses: 10,000
Net Operating Income: 24,000

Operating Expenses include the following items; advertising, insurance, maintenance, property taxes, property management, repairs, supplies and utilities.

Depreciation

Depreciation is the loss in value of an asset / building over time due to wear and tear, physical deterioration and age. The cost of reproducing an income property can be recovered over the useful life of the asset which is determined by law. Only the building can be depreciated and not the land.

Residential income property must be depreciated over a 27.5 year period using straight line depreciation. Commercial income property must be depreciated over 39 years using straight line depreciation. Straight line depreciation stipulates that an asset must be depreciated by equal amounts each year over its useful life.

Example: You purchase a warehouse for $900,000. The land where the warehouse resides is valued at $120,000. The building is valued at $780,000. Current law allows you to depreciate commercial properties by equal amounts annually over 39 years. Your depreciation deduction for the first year is based on the mid month convention.

The day of the month that you purchase the property doesn’t matter. You can only deduct half of the first months depreciation. If you put the warehouse into service on June 1, you are allowed to deduct 6 and 1/2 months of depreciation for the first year.

780,000
_____= $20,000
39

 20,000
First Year Depreciation = 6.5 X (_____ ) = $10,833
12

Accountants calculate a full year of depreciation for the above warehouse (commercial properties) by multiplying 2.56 % times 780,000 which equals 19968. A full year of depreciation for residential income properties would be calculated by multiplying 3.64 % times the building basis.

The depreciation deductions that you write-off in any year reduce you taxable income thus increasing your profit for that year. Capital improvements are subject to the same depreciation laws. Capital improvements include the following; a new roof, a new furnace, an addition to a building, siding, etc.

Example: You have owned the above warehouse for about 7 years now and it is in need of a new roof. The cost of the new roof is $19,500. You are allowed to depreciate the cost of the roof over 39 years. If you put the new roof on in July, you are allowed to deduct 5 and 1/2 months of depreciation in the first year.

19,500
______= $500
39
500
First Year Depreciation (roof) = 5.5 X ( ______ ) = $229
12

Accountants would calculate a full year of depreciation for the roof by multiplying 2.56 % times $19,500 which equal 499.
All depreciation amounts that you write-off in each year for the building and capital improvements reduce your adjusted basis for the property thus increasing the taxable profit you must declare when you sell.

Gross Rent Multiplier (GRM)

The Gross Rent Multiplier or GRM is a ratio that is used to estimate the value of income producing properties. It can be a useful estimation tool when current and detailed financial information is available for similar properties in a particular area or market.

If current information is available, the average GRM of similar properties sold in an area can then be used to estimate the value of other like properties. The GRM is calculated by dividing the sales price by either the monthly potential gross income or by dividing the sales price by the yearly potential gross income.

Example 1: If the sales price for a property is $200,000 and the monthly potential gross rental income for a property is $2,500, the GRM is equal to 80. Monthly potential gross income is equal to the full occupancy monthly rental amount which assumes all available rental units are occupied.

Generally speaking, properties in prime locations have higher GRM’s than properties in less desirable locations. When comparing similar properties in the same area or location, the lower the GRM, the more profitable the property from an income perspective. This statement assumes that operating expenses are proportionate for the properties being compared.

Since the GRM calculation doesn’t include operating expenses, this statement might not hold true for similar properties where one of the properties has significantly higher operating expenses.

Sales Price                      $200,000
GRM (monthly) = _____ = ______ = 80
Monthly Potential Gross Income   $2,500

Example 2: We have several similar properties that have sold recently and their average monthly GRM is 80. We can use this information to estimate the value of comparable properties for sale. If our monthly potential gross income for a property is equal to $3,000, we would estimate its value in the following way.

Estimated Market Value = GRM X Potential Gross Income = 80 X $3,000 = $240,000 

The GRM can provide a rough property value estimate when consistent and accurate financial information is available, but you should be aware of it’s limitations. Operating expenses, debt service and tax consequences are not included in the GRM calculation.

We could have a situation where two properties have approximately the same potential gross income, but one property has significantly higher operating expenses. The above formula would result in a questionable estimation of the market value for these properties. Also, the above GRM formula uses the monthly potential gross income and doesn’t account for vacancy factor which could have an impact on the accuracy of the property value estimates. This is why it is important to have accurate and detailed financial information for comparable sales when establishing a GRM or Cap Rate for income-producing properties.

The GRM is sometimes calculated using the effective gross income rather than the potential gross income thus incorporating the vacancy factor in the GRM calculation. Effective Gross income equals potential gross income minus the vacancy amount. When vacancy rates are a factor, using the effective gross income will produce a more reliable estimate. The capitalization rate is a more reliable tool for estimating the value of income-producing properties since vacancy amount and operating expenses are included in the cap rate calculation. The GRM is useful in providing a rough estimate of value.

Internal Rate of Return (IRR)

IRR (Internal Rate of Return) put simply is the annual yield on an investment. The After-Tax IRR calculation for each year uses the initial investment, the series of After-Tax Cash Flows and the After-Tax Sales Proceeds in a particular year to establish a return on investment. For example, if we were calculating an IRR 5 years in the future for an investment we would use the Initial Investment, the After-Tax Cash Flows for each of the five years and the After-Tax Sales Proceeds in year five, the final year, to calculate an After-Tax IRR for the investment.

The real estate model calculates an After-Tax IRR in years 1 through 10 using this method. Be aware of one thing when looking at the IRR calculations. If in year 5 you have a return of 15 %, this means that your After-Tax Cash Flows in each year are ran forward at 15%. When calculating the MIRR for Future Wealth, On Target allows you to determine what rate of return you would like to run your cash flows at. The MIRR for Future Wealth therefore provides a more accurate return on investment in each year.

Loan to Value (LTV)

The loan-to-value or LTV is a ratio between the loan balance and the market value of a property expressed as a percentage. For example, a property with a loan balance of $400,000 and a market value of $500,000 has a LTV of 80%.

Balance of Loans           $400,000
LTV = ______ X 100 = ______ X 100 = 80%
Market Value               $500,000

The LTV can be used to estimate the amount of equity you have in a property. If the LTV for a property is 75%, your equity position in a property is 100 minus 75 or 25%. You can then multiply .25 times the market value to determine the equity amount. Lenders may require mortgage insurance on loans with LTV’s that are greater than a predetermined amount, usually 80%.

This means that the purchaser of a property will need to put a minimum of 20% down to avoid paying mortgage insurance premiums. Mortgage insurance is a premium amount which is added to the monthly mortgage payment. The LTV is also used when an investor wishes to refinance a property.

For example, you have owned an investment property for a number of years and you would like to refinance the property to take cash out. Most lenders will allow a maximum of 75% the appraised value for the new loan amount. Lenders who refinance at LTV’s greater than 75% will usually charge less favorable interest rates.

Modified Internal Rate of Return on Future Wealth (MIRR)

The Modified Internal Rate of Return on Future Wealth is the best indicator to evaluate the overall return on an income property investment. Cumulative cash flows and gains resulting from the sale of the property are accumulated on a year-to-year basis to arrive at a Future Wealth amount. You determine the rate of return you would like to run your cash flows forward at.

The IRR calculation determines this value for you and may therefore exaggerate your return on cash flows. Also overestimating the appreciation growth rate can distort Future Wealth. Once you’ve narrowed down your property selections, you may want to run low, medium and high appreciation growth rate scenarios through the model. This will give you a range of Future Wealth possibilities.

Net Income Multiplier (NIM)

The Net Income Multiplier or NIM is a factor that is used to estimate the market value of income producing properties. It is equal to the market value of a property divided by the net operating income or NOI. Example 1: A residential income property has an NOI of $15,000 and a market value of $150,000.

Market Value     $150,000
NIM = ______ = ______ = 10
Net Operating Income  $15,000

Example 2: The average net income multiplier for comparable properties in a particular area is 9 and the net operating income for a similar property we are considering buying is $20,000.

Market Value = NIM X NOI = 9 X $20,000 = $180,000

The net income multiplier and the cap rate are financial tools used to estimate the market value of income properties. The cap rate is better known and more widely used. The cap rate and the NIM produce identical results when estimating the market value of an income property since the net income multiplier is the inverse of the cap rate. The cap rate is equal to 100 divided by the NIM and conversely the NIM is equal to 100 divided by the cap rate.

100              100
Cap Rate =______ NIM =______
NIM            Cap Rate

When using the capitalization rate and the net income multiplier to estimate the value of an income property, accurate and current financial data for comparable sales is required.

Leverage

Leverage is the use of borrowed money to increase your profits in an investment. Building wealth via real estate requires the use of leverage. Let’s assume you have $100,000 to invest and you purchase a small income property for $100,000. Income properties have been appreciating at an average of 7% per year. At the end of the first year of operation, your property is worth $107,000. At the end of year two, it is worth $114,490.

Now let’s assume that you put your $100,000 down on a $500,000 income property. At the end of the first year, it is worth $535,000. At the end of the second year, it is worth $572,450. By borrowing money to purchase a larger income property, you have increased your profit by $57,960 in just two years.

To get the full advantage of leverage put the minimum down on a good property which has a strong likelihood of appreciating in value. Stay away from questionable properties in run down areas. When you purchase a piece of real estate, you make use of leverage when you borrow money towards the purchase price. The principal of leverage can be demonstrated very easily with an investment model.