Smart Real Estate Investing: A Venture of Diligence and Foresight
Real estate investing is a venture of diligence and foresight, and investors with a good sense of where property rents and values are headed can be very successful. The most critical stage of the real estate investment process is the selection of specific markets and properties in which to invest. Real estate is fixed at a given location and its modification usually is very costly; unless the chosen property has inherent potential, there is nothing the investor can do to make the investment profitable. Investing in real estate is not riskless, but the better investors understand the dynamics that trigger rent and property value increases, the higher the likelihood that they will choose a property with stronger potential for high returns and lower risk.
Within this context, an important requirement of high-return real estate investing is the understanding of the circumstances that create opportunities for significant profits in real estate. This understanding will provide the basis for identifying general and specific categories of properties with significant profit potential.
I actually elaborate along this line of thinking in my over 200-page book entitled Real Estate Investing for Double-Digit Returns. The book provides a valuable framework of reference for applying real estate investing strategies targeting double-digit returns and identifying suitable markets, locations and types of properties for such strategies. The principles and conclusions presented in my book are universal and apply to any real estate market operating with the principle of free competition. As such it should be of great interest to property owners, investors, and real estate professionals residing in any free economy around the globe.
High-Return Real Estate Investing: Thinking Framework
As is the case for any investment, high returns in real estate investing is achievable if the property is sold at a price considerably higher than the purchase price. Such a strategy will be highly profitable since it will allow for large capital gains (in simplistic terms the difference between sales and purchase price). Selling at a price that is considerably greater than the purchase price requires that:
- The value of the property increases considerably after its purchase
- The property is purchased considerably below its market value, because of a rushed sale or other special circumstances.
The above statements represent common sense and by no means qualify as a revelation. Of great interest, however, is how these statements can be translated into more specific terms in order to provide clues for identifying highly profitable real estate investment opportunities.
Besides capital gains, which are key to real estate investing for double-digit returns, an additional source of profit for income-producing properties is the rental income received from the tenant. Strong increases in property income will give a double bonus to the investor because, all else equal, the value of the property will go up considerably as well. The value of a property increases when the income it provides to its landlord goes up (all else being equal) because in the asset market, where asset prices are determined, there is a vital link between the market value of a property and the income it produces. This link is described by two formulas. Formula 1 postulates that property value is the ratio of the property’s net operating income (NOI) over a rate referred to as the market capitalization rate (often referred to as the “cap rate”). Formula 2 clarifies that NOI represents the difference between the rental income produced by the property and its operating expenses, which typically include management fees, maintenance and repairs, salaries, utilities, insurance, supplies, advertising, and property taxes.
Property Value = Property Net Operating Income (NOI)/ Market Capitalization Rate (1)
Property Value = (Rental Income – Operating Expenses)/Market Capitalization Rate (2)
Formulas 1 and 2 represent what is called in the appraisal literature the “simple income capitalization approach” in estimating property value. Historical data provided by the National Council of Real Estate Investment Fiduciaries (NCREIF) prove the validity of this rule. NCREIF collects and processes property income and value data from the largest institutional investors in real estate in the United States. Appraisal-based market capitalization rates for office properties, estimated from this database using the above formula for the period 1979-2004, have ranged between 6.3 and 9.6%. Similarly, over the same period, market capitalization rates for retail properties have ranged between 6.2 and 8.9%.
As Formula 2 indicates, if the rental income of a property increases significantly, the value of the property will increase significantly too (assuming that the market capitalization rate does not change). The rental income of a property is determined by two factors: the rental rate per square foot and building occupancy. For example, two apartment buildings that charge the same rent but have significantly different occupancy rates will have different rental income and NOI. Therefore, increases in the rental income of a property can be triggered by increases in the rental rate charged to tenants and increases in its occupancy rate.
By transforming Formula 1, we see that the market capitalization rate is actually the ratio of NOI over property value. Thus, in essence, the market capitalization rate represents the income return earned by investors active in the real estate marketplace, but in actuality, it is the required income return by the investor for acquiring the particular property.
To better understand how the two components of the formula (NOI and market capitalization rate) influence value, assume that you own an apartment, which you are renting to a tenant, and receive an annual NOI of $10,000. This represents the rental payments minus the yearly operating expenses associated with holding the property. Assuming a market capitalization rate of 8%, the value of your apartment can be calculated as:
V = $10,000/0.08 = $125,000
Now, assume that during the second year you can charge higher rent so that property NOI increases by 5%. Assuming that market capitalization rates remain the same, the value of your apartment will also increase by 5% to $131,250:
V = $10,500 / 0.08 = $131,250
Notice that if the market capitalization rate goes up, income increases may not necessarily result in property value increases. If we assume that at the same time the NOI of your apartment rises by 5%, the market capitalization rate increases to 8.5%, the value of your apartment will actually decrease slightly to $123,529:
V = – $10,500 /0.085 = $123,529
However, if we assume that at the same time the NOI of your apartment increases, the market capitalization rate decreases, the percentage increase in your apartment will be considerably greater. For example, assume that during the second year, not only does the NOI increase by 5%, but also the market capitalization rate drops from 8% to 7.5%. In such a case, the value of your property will climb to $140,000, representing a 12% increase over its original value of $125,000:
V =$10,500 / 0.075 = $140,000
The conclusion is that robust property-value increases can be triggered by strong property-income increases, especially when they are combined with decreasing capitalization rates. Therefore, in order to formulate more specific high-return property investing strategies, we need to identify mechanisms, circumstances, and factors that trigger increases in property income and decreases in capitalization rates.
A key high-return property investing practice is the thorough evaluation and assessment of the acquisition price of the property considered so as to allow for high-returns, given its income-earning ability and its value appreciation prospects. Such evaluation is carried out using a complex model, the discounted cash-flow model (DCF), which takes into account not only the income the property is earning at the time of purchase, but also the anticipated income and expenses during every year of the assumed holding period, as well as anticipated profits or losses from changes in value over the holding period. When using this model, investors need to understand and assess the validity and robustness of the projections of property income and value that by necessity need to be used in order to assess its profitability over the planned holding period and estimate the expected return on their investment.
“Smart property investing requires a deep and comprehensive understanding of the forces and circumstances that drive increases in rents and property values” Petros Sivitanides, Ph.D.
Sivitanides, P. 2008. Real Estate Investing for Double-Digit Returns. BookSurge Publishing.
Geltner, M., Miller, N. G., Clayton, J., & Eichholtz, P. (2013). Commercial Real Estate Analysis and Investments (with CD-ROM). Oncourse Learning.
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