01/28/2020 | Investing
What Makes a Good Real Estate Investment?
Ownership of real estate is a tried and true path to accumulating and storing wealth. But what makes a good real estate investment?
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A well-known and well-followed path to wealth is one involving the ownership of rental property. Ever since personal property rights became widespread, ownership of rental income-generating real estate has been a reliable method to increase wealth over time. This strategy of buying rental properties has proven successful for many people, and has several hundred years of demonstrated effectiveness. With this understanding, how does one begin to think about valuing rental property?
To understand what a property is intrinsically worth, we must first understand the implied return from owning it. Current asset values, or relevant ‘transaction comps,’ are highly correlated to the market’s perception of future returns, although the relationship fluctuates through the market cycles. To understand value, one must answer the most fundamental question: what is the return to you as a property owner?
There are three return components:
Cash flow income itself is the net of two components – revenue and expenses. The revenue side is straightforward in that it is typically contractually-based lease income with some element of predictability. Market default rates, tenant turnover times, average market vacancy, and expected losses on non-collectible receivables always need to be layered into any conservative forecast of rental income before buying rental properties. However, in general, expectations of status-quo, current-market rental income can be reasonably understood.
The expense side of the equation is a bit more volatile. Some expenses are large and infrequent, such as hail damage, roof replacement, boiler failure, flood or fire, and all are almost inevitable over the long term. One way these can be accounted for is through adequate insurance or a repair and maintenance reserve, which is used to smooth out the unexpected bad luck. However, unusual and irregular capital expenses, premature aging of building equipment, and other maintenance requirements are always going to occur. Be sure that the calculation of expenses always includes some portion of the expenses that can potentially happen in any given year, and do not be lulled into complacency by thinking a few recent low-expense years are necessarily representative of the long-term average. Property taxes and total debt service expenses are two non-operating costs that also need to be subtracted from revenues to come to a true net cash flow number as you think through buying rental properties.
Once there is a solid understanding of the cash flows of the property, one must then get a sense of the capital structure. Either for a new acquisition or a currently owned property, the cash flow, debt paydown, and capital appreciation are applied to the equity value in the property to calculate the investment return. The equity value can be calculated as the market value of the property, less any transaction fees to monetize the property (for properties currently owned), less any taxes payable on gains (for properties currently owned), less any current or prospective outstanding debt – the net result is how much the investor could be investing in another opportunity given their current circumstances. Once a determination of equity value is made, the real estate investor can divide the sum of the cash flow income and debt principle amortization by the equity value to determine the current annual percentage return on the investment property.
One key observation from this analysis is that cheap leverage benefits returns. Net cash flows, relative to equity, will be enhanced with more low-priced debt. While increased leverage is accretive when times are good, it can also amplify losses when cash flows or property values are decreasing. Leverage is simply a magnifier of outcome, and when used successfully can increase returns. The opposite. of course, also holds true, as the imprudent use of leverage is one of the very few ways to lose your entire investment when purchasing real estate.
A second key observation as it relates to leverage is real estate’s sensitivity to interest rates. Assuming a fixed amount of debt on a property, the net cash flows are greater on a property with a lower interest rate, and vice versa. Using this logic, it is clear why, on average, fluctuations in real estate values have a high correlation to changes in interest rates. This must be considered when planning future exit opportunities – is the prospective buyer likely to have access to financing that enables adequate cash flow returns to justify required sale prices? The future is difficult to predict, so the less dependent an investment is on the exit, the more likely it is to have a positive outcome for the investor.
Another key observation is that over time, if cash flow remains relatively stable, returns will go down as debt is amortized and market values go up. If rental rates, and therefore expected cash flows, change at a rate that is lower than the growth in equity value through debt paydown and market value appreciation, simple math will show a decreasing rate of return. This implies returns need to be regularly evaluated to determine if they meet investor thresholds, and to see how they stack up relative to other opportunities in the marketplace. Increasing equity values relative to cash flows over time provides the investor with an opportunity to recapitalize, or sell the assets at a premium to what their underlying fundamentals may imply.
Valuing and investing in rental properties gets much more complicated when considering the third component of returns – property value capital appreciation. Theoretically, any increase in market values should be justified by increases in potential cash flows, but of course this isn’t always the case. In hot markets, it is the allure of capital appreciation that tends to move the market, but investors (as opposed to speculators) will always rely on adequate cash flow income and debt principle amortization as the true indicators of expected return. Any capital appreciation on an exit is just icing on the cake. Because increases in property values flow directly to leveraged equity, speculation is widespread in pursuit of these easy gains. Those investors that are most successful over a career will tend to enter into situations where they are exposed to the optionality of capital appreciation benefits (either through favorable developments in market sentiment or through justifiable cash flow increases), but they always rely on fundamental cash flows of an investment as the basis for justifying investments.
As you can see, investing in real estate is all a bit circular: the market value will determine the amount of debt that can be placed on the property, which will determine the aggregate interest expense, which will determine the cash flow which will determine the market value… When doing fundamental investment analysis, it is important for the prospective investor to fix one of the variable assumptions from which to do the evaluation. The easy anchor for the investor to put a flag in the ground is on price. At a fixed price, does the specified asset have the characteristics to meet buy or sell requirements? Fixating on this anchor can have its drawbacks, however, as assumption criteria can shift in order to accommodate certain deals. This is most easily seen in how investors look at market comps: if everyone else is justifying the prices paid, does that mean I should too? Are my assumptions too conservative if other people are buying there? You get the picture, as this is how market cycles are created.
A better metric to fix is for investors to predetermine their own personal required returns, and ruthlessly determine if those thresholds are likely to be met in any given real estate investment opportunity. A focus on the cash flows of the property, rather than the market values, is the most reliable indicator of investment success. If the investor first determines their own return hurdle, a little math will quickly tell them the price they are willing to pay for an asset (or a price at which they would sell), with minimal exposure to many psychological pitfalls that can corrupt otherwise good analysis. This may mean passing on more deals, but the idea is to select the right ones with the highest probability of successful outcomes over time.
Investing in real estate is a well-known strategy to generate income and grow wealth. The key questions to ask when valuing real estate are:
If an investor can confidently calculate and evaluate the answers to these questions, and then optimize for them, they will be well on their way to increasing wealth over the course of a real estate investing career.
For more information on how to value a property and investing in rental properties, contact Denver Realty Group today.