Rental Properties: Cash Cow or Money Pit?

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Rental Properties: Cash Cow or Money Pit?

Like with other asset, real estate investors must continuously decide whether to buy, sell, or retain their investments. And assessing the subject property is necessary for making such judgments. Using discounted cash flow or capitalization techniques to value real estate is comparable to evaluating stocks or bonds. The main distinction is that cash flows come from renting space rather than from selling goods and services.

To help them make judgments, real estate investment businesses have created complex valuation models. However, with the use of spreadsheet tools, a person may get a sufficient value for the majority of income-producing real estate, including residential property bought for use as a rental home.

Continue reading to see how any investor may produce a value that is sufficient for weeding out potential investment possibilities.

Individual Valuations

Some people believe that if a certified evaluation has already been done, creating a value is superfluous. However, there are a number of reasons why an investor’s value and an appraiser’s may disagree.

Depending on the investor’s perspective, the rental prices that renters are prepared to accept or the property’s potential to draw in tenants may change. The investor may believe that the property has more or less risk than the appraiser does as a potential buyer or seller.

Separate evaluations of value are performed by appraisers. They consist of an income approach, a comparison of current and similar transactions, and the cost to replace the property. Some of these techniques often trail the market, overvaluing assets during downtrends and undervaluing them during uptrends.

Finding chances in the real estate market entails looking for homes that the market has overpriced. This often entails managing a property above and above what the market would reasonably anticipate. An evaluation of a property’s actual ability to generate revenue should be included in a value.

Real Estate Valuation

The procedure for valuing stocks, bonds, or any other income-producing investment is comparable to the income approach to analyzing real estate. The majority of analysts utilize the discounted cash flow (DCF) approach to calculate the net present value of an asset (NPV).

The property’s net present value (NPV) is its current dollar worth when the investor’s risk-adjusted return is realized. The monthly cash flow available to owners is discounted by the investor’s necessary rate of return to get the net present value (NPV) (RROR).The value obtained is a risk-adjusted value for that specific investor since the RROR is the investor’s needed rate of return given the risks involved. A choice to purchase, hold, or sell may be made by an investor by comparing this value to market pricing.

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Bond values are created by discounting interest coupon payments, whereas stock values are created by discounting dividends. Net cash flow, or the cash available to owners after all costs and lease revenue have been subtracted, is discounted to determine a property’s worth. A property’s value is determined by assessing all rental income and subtracting all costs associated with signing and upkeep of such leases.

Breaking Down Leases

Estimates of income are all based only on leases. Contractual arrangements known as leases are made between renters and a landlord. The contracts will include all rent, contractual rent hikes (escalations), and alternatives for space and rent reductions. Additionally, owners recover all or a portion of their property costs from renters. The leasing agreement also specifies how this revenue will be collected. The three primary forms of leases are as follows:

Tenants on full-service leases, also known as gross leases, do not pay any additional fees. Tenants often pay their share of the rise in costs for the time after they move into the property under net leases. The tenant bears a pro rata portion of all property costs under triple-net leases.

The sorts of costs that must be taken into account while creating an income appraisal include the following:

  • Leasing costs
  • Management cost
  • Capital costs

The fees required to negotiate leases and entice renters are referred to as leasing charges. Management costs include both fees to manage the property and property-level expenses like utilities, cleaning, taxes, etc. Net operational income is the result of revenue minus operating expenditures (NOI).The cash flow generated by a property’s regular business activities is known as NOI. Capital expenses are then subtracted from NOI to calculate cash flow. Capital expenditures for property maintenance are referred to as capital expenses. These consist of any funds set aside for leasing commissions, tenant improvements, or future property improvement capital reserves.

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Valuation Example

Periodic cash flows may be calculated and then discounted back to get a property’s worth. A basic valuation scheme that may be modified to value the majority of properties is shown in Figure 1.

Growth in Income Yr1-10 (g)4%Growth in Income Yr11+ (g)3%
RROR (K)13%Expenses % of Income40%
Capital Expenses$10,000Reversion Cap Rate (K-g)10%

Figure 1

The value makes the assumption that the property generates a $100,000 rental revenue in year one, which increases by 4% yearly and by 3% after year 10. An estimated 40% of revenue is spent on expenses. Modeled capital reserves amount to $10,000 annually. The RROR, or discount rate, is set at 13%. The expected capitalization rate for calculating the property’s reversion value in year 10 is 10%. This capitalization rate is expressed in terms of K-g, where K is the investor’s RROR (required rate of return) and g is the anticipated increase in revenue. K-g, or the portion of the total return that is delivered by income, is often referred to as the investor’s needed income return.

The expected NOI for year 11 is divided by the capitalization rate to get the value of the property in year 10. The capitalization would be equal to 10%, or K-g (13% – 3%), if the investor’s needed rate of return remained at 13%. Figure 2 displays NOI for year 11 at $88,812. After calculating monthly cash flows, they are discounted back using the discount rate (13%), which results in an NPV of $58,333.

ItemYr 1Yr 2Yr 3Yr 4Yr 5Yr 6Yr 7Yr8Yr 9Yr 10Yr 11
Net Operating Income (NOI)6062.4064.89667.49470.19473.00275.92478.9682.11685.39888.812
Cash Flow (CF)5052.4054.9057.4960.196365.9268.9672.1275.40
Total Cash Flow5052.4054.9057.4960.196365.9268.9672.12963.52
Dividend Yield9%9%9%10%10%11%11%12%12%13%

Figure 2 (in thousands of dollars)

A basic structure for valuing any income-producing or rental property is shown in Figure 2. Investors buying residential real estate to rent out should conduct appraisals to see if the rental rates are sufficient to cover the cost of the property. Despite the fact that appraisers often use a 10-year cash flow as a default, investors should generate cash flows that reflect the presumptions used to estimate the cost of the property. Despite being straightforward, this format may be modified to value any attribute, no matter how complicated. In this sense, even hotels might be valued. Consider daily room rents to be one-day leases.

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Buy, Sell or Hold

If an investor’s assessed value when buying a property is higher than the seller’s offer or appraised value, then the property might be bought with a strong likelihood of earning the RROR. In contrast, if a buyer’s offer is more than the assessed worth of the property, the property should be sold. Additionally, the owner may choose to maintain the investment until there is an imbalance between the assessed value and market value provided the assessed value is in accordance with the market and the RROR delivers a sufficient return for the risk involved.

Value is characterized as the highest sum a buyer would be willing to pay for a piece of property. Because each buyer has a variety of financing choices at their disposal, finance shouldn’t have an impact on the asset’s final worth while making a purchase.

For investors who already own houses that have been funded, however, this is not the case. When choosing when to sell, investors must take finance into account since some financing provisions, such as prepayment penalties, might deprive investors of the rewards of their sales. When investors have gotten advantageous financing arrangements that are no longer offered on the market, this is crucial. Reinvesting the anticipated sales profits might result in lower risk-adjusted returns than the current debt investment. Add the extra financial risk of home debt to the risk RROR.

The Bottom Line

It is feasible to create a valuation model that is precise enough to help in the decision-making process, whether you are buying or selling. Most investors can understand the very simple arithmetic that went into developing the strategy. One should be able to predict future cash flows after they have a basic understanding of local market norms, lease arrangements, and how revenue and costs operate in various property kinds.

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