Evaluating Real Estate Investments Like a Pro: Present Value
When you consider that there are many real estate opportunities where you think you could make a killing, how can you really be sure that one investment is better than another? Many would-be investors jump into real estate without a good way of determining whether a particular piece of property, a single family home, resort condo or a multi family dwelling is really and truly a good investment. The end result is often disappointing. Maybe you should have bought investment B instead of investment A. And so it goes…What is the best way of evaluating real estate? The following approach is the way large companies utilize a very important, yet relatively simple evaluation tool for comparing competing investments.
A Couple Fundamentals, First
Obviously, if you are a real estate investor, you probably have decided on a minimum rate of return or minimum amount of money that you would expect yearly on a real estate investment. Of course, there are some investments that you can immediately jump into without doing very much evaluation. Suppose you can snap up a home that is selling for 60% less than its current value and you’re very sure that without upfront repair/refurbishment expenditures, you can immediately sell it, realizing an attractive profit. The answer is obvious upfront. Most times, these opportunities are hard to find and often the listing real estate agent is in the best position to takes advantage of these situations.
Also, we’ll need to assume that there are no legal barriers, potential zoning regulations or other problems that would immediately preclude one investment over the other. Moreover, you as an investor will need to assume that all of your information is imperfect and the future is almost always unclear about investment choices you make. Thus, the following approach to evaluating competing real estate investments is based purely on financial returns. Let the numbers do the talking!
Present Value Overview
The basic approach to present value boils down to an obvious fact: a dollar today is worth more than a dollar that will be received at some time in the future. For instance, what would you rather have: a $100 return now or $100 return in 2 years? Obviously now, but when you start making that future $100 grow, there will be some point at which you will decide in favor of the latter.
Assuming the worst is always a safer strategy. In present value, it is more reasonable for you to assume that any rents, receivables, rates of return, rate of appreciation and occupancy rates will typically be less than you want and expect. As you assemble the facts for your analysis or business plan, be very conservative and this is especially the case if you’re seeking funding from a bank, venture capital source or investment group.
Present Value Internal Rate of Return Methodology
As mentioned above, money has a time value. Albert Einstein was quoted as saying, “The most powerful force in the universe is compound interest”. The so called internal rate of return analysis is all about that. The Microsoft product, Excel allows a relative financial neophyte to analyze side-by-side alternative investment cash flows in terms of its compound interest time value
A Basic Example
Let us say that you have two properties that you’re might considering. The first is a home that you can purchase for $100,000 with $25,000 down. The second is a condominium that has a price of $75,000, but can be purchased directly from the builder with only $7,500 as the down payment. Let’s assume that both will appreciate at 5% per year and by the end of three years, you would be able to sell either for a 15% profit over your initial cost. Let is assume that you can rent these properties resulting in the following:
1. You receive a net $100 per month profit after your mortgage payment on the single-family home.
2. You can realize $50 per month net profit on the condo.
Which is the better investment?
|
Home
|
Condo
|
|
|
$100,000 |
$ 75,000 |
|
Down Payment:
|
25000
|
7500
|
|
Yr 1
|
1200
|
600
|
|
Yr 2
|
1200
|
600
|
|
Yr 3*
|
$41,200 |
$19,250 |
|
IRR
|
21.1% |
41.6% |
*Year 3 includes the yearly net rent, the return of the principal ($25,000 and $7,500, respectively) and profit.
The image on left shows what the Excel format would look like.
In the basic financial terms, without even considering individual any federal or state income tax rates that apply, the best investment would obviously be the condo’s rate of return which is more than double the rate of the investment on the home
Now extending the investment horizon to 6 years, with the same sales price and the same rents, the condo is still the best investment, but the rates of return falls drastically. The home has a rate of return of 12.2% and the condo has a return of 22.3%.
How to Use the Excel function
Using Excel to set the example up is simple:
The Excel formula is IRR(Cash Flow1, Cash Flow2. Cash Flow3,Guess at Rate). On the Excel spread sheet it will be expressed as follows: =IRR(-C2:C5,19) where C2 is the initial investment (down payment with a bracket surrounding it, designating that it’s a negative flow) and C3, C4, C5, etc. which are the yearly (or monthly cash flows).
The last number, 19 is a ‘guessimate’ of the what the rate might be. I could used 5, 10, etc. Excel uses this as a function, but it really doesn’t matter whether you’re accurate or not.
You can obtain additional information about IRR directly from Microsoft
Obviously you can make this as complex as needed. For instance, you might want to use a factor for federal income taxes, a factor for expected repairs and even increases in rent and real estate taxes. You may also assume occupancy rates. It really doesn’t matter as long as the formula is set up in the correct Excel format. You can make it as precise as you need. But keep in mind that too much precision into the future is largely wasted effort. This approach to analysis only requires you to be reasonable in all your assumptions.
There are numerous ways of performing real estate investment analysis. While you can’t ever know the future, you can assume typical terms, conditions and the types of rates that most banks or investor groups will demand of the real estate investor.
