As you think about diversifying your portfolio into Real Estate, or building onto your existing Real Estate holdings, it’s important to understand basic concepts related to Real Estate valuation. This brief overview reviews a few of the fundamental methods used to value a real estate asset.
The value of a real estate asset is directly related to the income it is currently producing or expected to produce in the future. Often, this income is expressed as Net Operating Income (NOI), which is calculated by subtracting a property’s expenses from its revenues. This Net Operating Income can then be used to help calculate the value of a property, often directly through a metric referred to as the capitalization rate (cap rate).
The capitalization rate is the most essential metric in real estate and perhaps the most commonly used in valuing investments. It is expressed as the ratio of a property’s NOI to its value. For example, if we knew a building had an NOI of $2 million and could assume a 5% cap rate based on the market in which the building is located, we could calculate the property’s valuation by dividing the NOI by the cap rate to yield a result of $40 million. Similarly, if we were trying to calculate the cap rate itself having been given the property value and its NOI, we could simply divide the NOI by the property value to find the cap rate. The 5% cap rate on our example valuation means that investors would receive a 5% yield on their investment if all available income were passed through to investors, assuming the building has no debt.
A high cap rate, as with high yields for stocks and bonds, does not necessarily indicate a bargain opportunity. As the cap rate is essentially the reverse of the P/E ratio used in the stock market. Just as historical P/E ratios can be used to identify potential opportunities in the stock market, historical cap rates can be used to evaluate real estate investments. A lower historical cap rate could be indicative of a potential investment opportunity, such as if the NOI for a building is temporarily lower due to increased vacancy.
Historical cap rates for a given market could also indicate which markets are popular with investors. Markets and asset classes with low cap rates would indicate that investment opportunities are scarce. For example, cap rates for multifamily assets in large cities such as New York and Seattle have been decreasing over time, signifying that yield on investments in these cities is hard to come by due to the popularity of these markets. Historically low cap rates, just as with low yields for stocks and bonds, would indicate that investment in a given market or asset class is relatively low-risk. Inversely, historically high cap rates for a given market or asset class could indicate a potentially profitable investment opportunity, but one that carries relatively more risk. While the cap rate is a very valuable metric in evaluating real estate, it is not the only thing to consider when looking at a property. Any change in the property’s NOI or in its valuation would impact the cap rate, so understanding the value of each component is important for investors.
Another important way of analyzing a potential real estate investment is to examine other comparable transactions within the market you are considering. The transfer or sale of properties of a similar size, vintage (year constructed), and quality within the same market are worth looking at to see how other investments are being valued, providing another basis for an informed investment decision. Various aspects of these comparable transactions should be considered, but a main factor is often at what capitalization rates are comparable properties being valued. Additionally, sale prices are often quoted on a per-square-foot (or per-unit) basis rather than an absolute number basis, given the differences in size of some properties in the same market. Taken all together, comparable transactions can give an indication of how to analyze a subject property on a cap rate and per-square-foot basis, which can help investors arrive at a reasonable valuation combined with other metrics and valuation methods.
Another useful way to value real estate investments is through a discounted cash flow (DCF) analysis. DCF is a tool that is used to help estimate the price that investors should pay for a property by calculating the present value of future annual cash flows over a given period of time. This calculation is a bit more complicated, but it’s important to understand the fundamentals.
All DCF valuations assume a ‘discount rate’ to arrive at the present value of an investment’s cash flows. For example, if someone invests $100 today and has a guaranteed 5% annual return, that $100 would be worth $127 in 5 years (and vice versa). That assumption of how much money you could very likely have down the line in an alternative investment can be used to evaluate investments today. The 5% in this example is referred to as the discount rate. Beyond the discount rate, other assumptions including NOI, debt, and cash flows must be considered in building a DCF valuation. DCF analysis also requires a ‘terminal value’, which is the anticipated value at time of sale in a set number of years.
The important thing to note is that the value of an asset using DCF can be different than when only cap rate and NOI are considered. There are many different ways to value a real estate investment, all of which are important in their own right.
September 1, 2022
The goal of this article is to offer practical guidance on how to begin building a real estate portfolio, and how the risk and return profiles of different assets fit together.