THINKING FRAMEWORK
This is an excerpt from the book Real Estate Investing for Double-Digit Returns by Petros S. Sivitanides, Ph.D.
As is the case for any other
investment, high returns in property investing can be achieved if one can sell
considerably higher than the purchase price. Such a strategy will be highly
profitable, since it will allow large capital gains (the difference
between sales and purchase price). Simple logic suggests that selling at a
price that is considerably greater than the purchase price requires that:
a) The value of the property increases considerably after its purchase
b) The property is purchased considerably below its market value, because of a rushed sale or other special circumstances
Within this context, highly profitable property investing strategies need to
focus on properties that have significant prospects for value increases or can
be bought at a significant discount. Besides
capital gains (increases in value), an additional source of profit for
income-producing properties is the rental income received from the tenant. A
profitable property investing strategy should pursue both of these sources of investment
return.
Strong increases in property income will give double bonus to a
property investor because, all else equal, values will go up considerably too. The
value of a property should increase when the income it provides to its landlord
goes up (all else being equal), because in the capital 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 = Net Operating Income/Market Capitalization Rate (1)
or
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. Market capitalization rates for
office properties, estimated from this database using the above formula from
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 charged
per square foot and building occupancy. For example, two office
buildings that have the same net leasable area (NLA) and charge the same rent per square foot, 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.
Based on the discussion so far, it is obvious that the concept of
capitalization rate is very important in the property investing terminology. By
transforming Formula 1, we see that the market capitalization rate is actually
the ratio of NOI over the property value. Thus, in essence, the market
capitalization rate represents the income return earned by investors active in
the real estate marketplace. This is shaped
by forces in the capital market and the real estate market.
In developing a property investing strategy it is important to better
understand how the two components of the formula (NOI and market capitalization
rate) influence value. To this aim 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 developing profitable
property investing strategies, investors need to identify mechanisms, circumstances,
and factors that trigger increases in property income and decreases in
capitalization rates.
Property investing and, in general, real estate investing, for double-digit returns is a multi-stage process that requires a thourough understanding of the structure, dynamics and prospects of the local market and the successful implementation of the strategy selected.
Profitable property investing requires
strategizing to determine
appropriate timing, as well as
the property types and locations to invest in order
to maximize profits; sourcing the market and finding properties that
fit the specifications of the investment strategy selected;
finding data and thoroughly analyzing all
aspects of the selected properties (physical characteristics, immediate and broader location, accessibility, zoning provisions, legal issues, financial characteristics, etc.)including the
estimation of the expected internal rate (IRR) of the investment;
finding capital for the acquisition of the property (if borrowed funds are to be used, which is often the case); structuring the transaction in terms of ownership and other provisions; executing the transaction; effectively managing the property once owned and over the holding period; and reselling at the appropriate stage of
the real estate cycle in
order to maximize capital gains (gains from increases in property value). Within this context, the mission of the site is to provide a comprehensive Information, Knowledge, and
Recourse Center that will help real estate investors around the globe more effectively and successfully implement each of the stages
of the property investing process.
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