PROPERTY INVESTMENT SELECTION• Furthermore, the expected return needs to be weighed against the risks stemming from local market conditions and the characteristics of the property and its location, in order to evaluate whether it is high enough to compensate the investor for the risk that is undertaken by acquiring the property. For example, the risk associated with the expected return for a multi-tenant office building with a large tenant whose lease expires soon is greater than the risk associated with the expected return of another office building that is occupied by tenants with leases that expire in 15 years. Of course, if the market is efficient, the former property should be traded at a lower price, all else being equal, in order to compensate the investor for the higher risk and allow for a higher expected return. From a property investment selection point of view, it is very important to understand that the return achieved by a property investment has two components: • Income return The income return that can be achieved by a property is measured by the ratio of the Net Operating Income (NOI) over the acquisition cost, which includes not only the purchase price but also ny other expenses associated with the completion of the transaction, such as consultant fees, title search, etc. For example, if the acquisition cost is $200,000 and the property produces a net operating income of $12,000 then the income return offered by this property is: Income Return = $12,000/$200,000 = 6% This article explains how the NOI is calculated. Notice that according to the data provided by the National Association of Real Estate Investment Fiduciaries (NCREIF), income returns for investment-grade property have ranged historically mostly between 5% and 8% depending on property type. The second component of real estate investment returns is the appreciation return, which represents the profit resulting from the increase of the capital value of the property above the acquisition cost. Notice that property values DO NOT ALWAYS INCREASE and may experience severe declines depending on market conditions. The case of the global financial crisis of 2008 when investor demand for real estate collapsed and property values registered declines in excess of 20% in many countries is a perfect example of negative capital returns. Keep in mind also that property values in a local market can decline due to localized market conditions, independently of whether there is a global financial crisis or not. The formula for calculating the before-tax appreciation return is the following: Appreciation Return = (Sales Price – Sales Cost – Acquisition Cost)/Acquisition Cost In order to make sense of these returns we need to annualize them since usually the time between acquisition and resale of the property is more than one year. This article explains how to annualize expected appreciation returns. Given that income returns typically range between 5% and 8%, achieving double-digit returns, and specifically in the high teens, requires that property investment selection focuses on properties that have strong price appreciation potential. Typically, in evaluating return prospects for property investment selection purposes we calculate the after-tax capital return, which requires the calculation of the capital gains taxes that need to be paid upon the sale of the property to the tax authorities. In order to calculate the capital gains tax, we need to calculate first the capital gains amount and then apply to it the capital gains tax rate, as specified by the IRS code. The IRS code dictates that the capital gains amount is calculated by deducting from the sales price the so called “adjusted basis”, which is explained in this article. Property investment selection typically aims at maximizing total return for a given level of risk. Based on the methodology applied by NCREIF, the total return of a property investment is calculated by adding the income return and the appreciation return. So, if the expected annual income return is 6% and the expected annual appreciation return is 3%, then the expected total annual return is 9%. However, the proper calculation of the return of a property, in a typical property investment selection case in which the property is expected to be held over a number of years and has different expected cash flows each year, is more complicated and requires the use of the Discounted Cash Flow Model (DCF model) and the calculation of the so called Internal Rate of Return (IRR). Property investment returns can be enhanced through the use of leverage. The basic conclusion from this discussion is that the capital appreciation prospects of a property represent a very important criterion for property investment selection, especially in the case of property investors aiming at double-digit returns, and underscores the need for locating and acquiring properties that are likely to experience strong value increases. The book Real Estate Investing for Double Digit Returns (which is part of the Real Estate Investment Mathematics Mega Bundle) focuses exactly on this topic and provides many tips to investors for identifying and locating such properties. It is obvious that the capital/appreciation return of a property will depend on how much the value of the property will change between the time of the purchase and the time of its resale. This change will be determined by the local market conditions and price/rent dynamics. Prudent property investment selection requires a very good understanding of such dynamics.
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