How to Estimate Future Property Value

Future property value is very important for property investors targeting double-digit returns. The reason is simple. The total return achieved by a property investment consists of two components: the income return and the capital (appreciation) return.  The income return is typically calculated as the ratio of the property’s net operating income (NOI) over its market value or acquisition price.  The capital return is typically measured as the annualized increase (or decrease) in value over the holding period (minus any sales costs). For the after-tax appreciation return we need to deduct of course taxes on capital gains. See my post  Property Investment Basics: Capital Return for more on this.

The typical income return for residential, retail and office property in the US ranges from 5% to around 8% depending on the property type under consideration. Within this context, achieving double-digit returns through real estate investments requires decent increases in property value over the investment’s holding period. Thus, the expected future property value at the end of the holding period needs to be high enough compared to the purchase price, so as to provide a decent annual appreciation return after capital gains taxes and sales costs are deducted.

Future property value can be calculated using three techniques:

  1. By applying an average/constant annual growth rate to the current property value, after understanding recent trends and taking into account the existing local market conditions and the stage at which the property price cycle it is at the time of analysis for the urban area/city under consideration
  2. By using the econometric property value forecasting technique, which in short requires the following two steps in order to be applied to a particular property:
    • Produce year-by-year forecasts of property value growth rates for the property type represented by the property under consideration and for the urban area within which the property is competing with other similar properties, using robust econometric techniques
    • Subsequently adjust these forecasted annual growth rates accordingly taking into account the idiosyncrasies and attractiveness of the property under consideration and its location
  3. The third methodology for calculating future property value, which applies to income producing properties, involves the following three steps:
    • Produce year-by-year forecasts of rent growth rates for the property type that represents the property under consideration and for the urban area within which the property is competing using again robust econometric techniques
    • Produce annual forecasts of the Net Operating Income (NOI) of the property under consideration over the holding period, taking into account its existing lease roll and by applying the econometric forecasts of market rent growth rates – adjusted to reflect the idiosyncrasies of the property and its location – to expected lease renewals and to new leases for vacant space expected to be signed in the future
    • Calculate the future property value for the expected year of exit from the investment (let’s say at t+n where t is the time of analysis and n is the number of years for which the property will be held) by dividing the property’s expected NOI at time t+n over the market cap rate (MCR) at time t+n:

Future Property Valuet+n = NOIt+n/CRt+n

 Of course this would require actually to produce also a forecast/prediction for the market cap rate at the anticipated time of exit, which could be three, five or even more years ahead. Given that the reliability of a forecast declines exponentially as we extent the forecast horizon beyond the three years, my advice would be not to even venture to produce forecasts longer than five years, as in my opinion they are very unreliable making the results of any analysis highly questionable.

Putting aside complicated and data-intensive econometric forecasts, perhaps the easiest way to come up with a relatively sensible forecast of future market cap rates is to use as basis the cyclicality of the market. In particular, as I explain in my post  How to identify property markets for capital gains?  cap rates move mainly in a counter-cyclical way in relation to the property price and rent cycle. In other words, when the market is strong with rising prices and rents market cap rates tend to decrease, while the opposite takes place when the market is weak with falling prices and rents. So we can get a sense of whether the market cap rate three-five years ahead will be higher or lower than the market cap rate at the time of analysis by understanding at what stage of the cycle the market for the particular property type is using constant-quality indices, which show historical and recent movements of property prices and rents. If, for example, the index shows that values/rents have just turned up from a long downturn, suggesting that we are at the beginning of the upward leg of the property price cycle, then it would be reasonable to assume that with continuing price and rent growth market cap rates should be declining, and for a planned exit three-four years ahead, market cap rates are likely to be somewhat lower than today.  However, caution is required here, because even if a lower market cap rate is predicted for the time of liquidation, this would need to be adjusted upwards for the particular property which will be sold three-five years ahead for two reasons:

  1. Due to physical and functional depreciation because the investor at the time of liquidation will be selling a building that will be three-five years older
  2. Due to the uncertainty of projected cash flows of the property for the next three-five years.

In sum, deriving accurate predictions of future property value is a quite difficult task and whichever way it is carried out, even with the most advanced scientific techniques, it is quite unlikely that they will turn out to be very accurate and exactly the same with the actual value of the property three-five years ahead. For this reason smart real estate investors need to understand thoroughly the sensitivity of expected returns to alternative property value forecasts and acquisition prices before deciding to acquire a property and the maximum price that they would be willing to pay for it.

Author: Petros Sivitanides, Ph.D.

Dr. Sivitanides is a seasoned expert in real estate investment strategy and analysis, property portfolio modeling and strategic analysis, and real estate market research and econometric forecasting with over 16 years of experience with leading global real estate investment managers and real estate consultants (CBRE Global Investors, AXA Real Estate, Torto Wheaton Research, DTZ, etc.). He is the editor of the textbook titled “Market Analysis for Real Estate”, which has been used as the main textbook for a graduate course at Harvard University. He is also the author of the book "Real Estate Investing for Double-Digit Returns" and many widely quoted articles that have been published in popular real estate journals. Currently, he is the Head of the Real Estate Department at Neapolis University in Cyprus, and an international real estate consultant.

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