There are three commercially recognized valuation models for real estate: the “comps” approach (comparable market analysis), the “income capitalization” approach (cash flows) and the replacement value approach.
If you’re looking to buy an investment property, you’ll likely want to use the income capitalization approach to determine whether you’d be getting a fair deal. Here’s a breakdown of how it works:
As a refresher, the comparable market analysis approach theorizes that a property that is similar in size, style, age, finishes, location, views and all other characteristics should be worth about the same amount as other comparable properties in its general vicinity around the same date of sale. One property is comparable to another.
The income capitalization approach does the same thing, except instead of using the comparable information about the physical aspects of the property, you primarily use the net operating income (NOI) the property can generate as the comparable feature and determinant of value.
NOI is calculated as the rental income, less all the operating expenses, before taking out the mortgage payment.
Example: Let’s say apartment Building A in La Mesa, CA has NOI of $100,000 and sells for $2,000,000. That’s a capitalization rate of 5 percent — NOI divided by purchase price.
If 20 separate apartment buildings in the general vicinity of La Mesa sold with cap rates of 5 percent in the past 90 days, and another apartment building comes on the market, it probably would also sell for a 5 percent cap rate.
Let’s say a building with NOI of only $35,000 comes on the market. Because the general average cap rate is 5 percent, you’d divide $35,000 (NOI) by .05 (cap rate) to get a value of $700,000. So any apartment building income stream in a similar area can be capitalized by the average cap rate to get an approximate valuation.
This method works best when comparing similar types of buildings, such as apartment buildings to apartment buildings, not apartments to retail or apartments to office.
The income capitalization approach provides an approximation of value and can never supplement determining your cash-on-cash returns on any particular property.
So use the income approach to valuation as you like but always fall back on this question: Are the realistic cash-on-cash returns that I project I will earn on this deal fair enough to make this investment an attractive option?
If you’re interested in improving your lot in life — no pun intended — by becoming a property mogul and investing your hard-earned capital into income-producing properties, there are some general guiding principles that should increase your chances of earning wealth.
One of the better ways to improve your wealth is to reduce your risk on the properties you purchase. This will allow you to buy lower-risk real estate, which hopefully will earn a fair amount of wealth for you over time. Go for these:
Properties in very good shape
Too many people buy fixer-uppers thinking they’ll add value by doing a renovation. Then they get mired in a much more expensive and time consuming property than they ever expected. More money into the property means lower investment returns for you and less wealth-building than you expected. Skip fixers and instead buy properties that are in as good shape as possible, which should get those rental checks coming into your bank account in as short a period as possible.
Properties in moderately priced areas with good cash flows
Real estate is all about location, location, location! The properties in the best locations (think beach areas, downtown, wealthy enclaves) generally have very negative cash flows, so those are the location, location, locations you want to avoid. The moderately priced properties in working-class areas are the real gems; they generally have the boring locations, but much better cash flows. Of course pencil out any deal with conservative rents and expenses, and go for beginning year cash on cash return of at least 4 to 6 percent, based on your conservative estimates.
Communities with HOAs in good financial, legal, operational shape
There are many, many landmines in buying properties in common interest developments. And you aren’t just buying your property; you’re buying into a larger entity called the homeowners association (HOA). And if it is in financial, legal or operational trouble, you pay the bills. Make sure to do your due diligence on this — and it’s a lot of hard work to do it properly. Learn what you need to look at way before you go into escrow.
Properties that come with decent credit quality tenants in place
There is nothing better than buying a property with a decent tenant already in place. You get the security deposit and pro-rated rent, and you don’t have to go in and clean, paint, update or fix too many things in the unit. If you buy properties in areas that have decent credit quality tenants, that’s hopefully the type of tenant you will inherit. Also take a look at the current tenant’s lease, credit application and credit report, if you can, before you make the decision to purchase the property.
Properties in low vacancy areas
Vacant units get robbed, incur vandalism and don’t have any rent coming in to cover the bills. If you buy in places with really high vacancy, it might be months or years before you get the property rented out at a fair rental rate. So really think through buying properties in areas with many unoccupied units. Drive around at dinner time: No lights in a lot of neighborhood houses means no one is residing there, and you shouldn’t, either.
Properties you will own a long time
The most important factor in real estate investment property is to own it for a long time — in fact, forever is the optimal ownership horizon. So do your due diligence and buy quality properties that you really like for all the right reasons, and plan to own them for good. That’s your best bet to earn wealth on real estate.
If you buy properties with ALL the above characteristics, that will greatly increase the chances you will add wealth to your nest egg from your real estate ownership. So try to acquire properties that have as many of the above good qualities as possible, and skip the ones that don’t make the cut!
Leonard Baron is America’s Real Estate Professor – his unbiased, neutral and inexpensive “Real Estate Ownership, Investment and Due Diligence 101” textbook teaches real estate buyers how to make smart and safe purchase decisions. He is a San Diego State University Lecturer, blogs at Zillow.com, and loves kicking the tires of a good piece of dirt! More at ProfessorBaron.com.
Note: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinion or position of Zillow.
When the article above states that long time ownership is the optimal situation, it may not always be true. Good investment property earns money for you three ways. Cash flow, appreciation, and depreciation. Every three to seven years it is worth having conversations about expectations for the property. Is it obsolete? This does not just mean that maintenance and repair costs are putting more money into the property than it can be worth in the existing neighborhood. It can also mean that the nighborhood ( no matter what the condition or amenities of the property ) will no longer support an increase in rent. Possibly the biggest concern and one that your CPA should provide assistance with is whether your cost basis for depreciation is causing you to lose money. Cost basis for depreciation should be market value of the property when you start. After seven years the depreciation schedule may reduce your tax break to the point where you need to consider a 1031 exchange of the property.