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Center for Real
Estate Studies ¨ Cal State Properties ¨ Cal State Investment LTD Partnership
Media Contact: Center for RE Studies For
Immediate Release
Property Analysis Essentials
Before you start to analyze property there is one “Rule” you
should know about. Only after your real estate investment is under contract,
should you prepare a comprehensive analysis that calsstatecompanies discuses in
this article. Don’t waste your time and money before you legally control the property.
THE
KEY FIGURE IN EVALUATING INVESTMENT PROPERTY
The key figure is the internal rate of return (IRR) after
taxes. By comparing this figure with the IRRs from other investments, you will
be able to determine the best investment for you.
It is critical to understand why the IRR is important when
analyzing real estate investments. The IRR shows the time value of money, and
it reflects cash flows based on present values. Return on investments, in terms
of purchasing power, might actually be less, depending on how the cost of
living has changed. Knowing the IRR will help to further quantify your investment
opportunities.
Your analysis should be based on two types of returns,
growth rate and replacement costs. Growth rate projections are based on
historical trends. An analysis performed using this rate will give you a
conservative IRR. An aggressive IRR is obtained by projecting a future selling
price based on future replacement costs. Use both when analyzing buildings.
Knowing both will give you an edge when negotiating.
What you should be looking for is steep growth. Buy complexes
below the cost of replacement. Sell them when values are at least equal to or
greater than replacement costs. This is how to become wealthy!
A
SOUND DOWN-MARKET STRATEGY
In a down market, your strategy is to buy as far below
current replacement cost as possible. To determine the current replacement
cost, consult local building associations or your web site for the Marshall
&Swift Valuation Service (M&SVS). M&SVS provides information on the
construction costs of different types of buildings through-out the United
States show how costs differ based on style for three types of buildings. Local square footage costs can be calculated
using the conversion chart applicable to each area.
ANALYZING
REAL ESTATE INVESTMENT
The methods to analyze real estate investments depend on the
availability of information. They are as follows:
• Qualified appraisers
• Comparable sales data or “comps”
• Gross multiplier approach
• Capitalization rate method
• Essentials of real estate
investment analysis software
We prefer using a specially designed computer program in
conjunction with input from consultants and comparable sales data. Since the final
decision rests with us, we want to be absolutely certain of our sources.
Qualified
Appraisers
Appraisers use three appraisal techniques to establish the
current market value. They are the (1) cost, (2) income, and (3) market data
approaches. The cost approach establishes market value based on what it would
cost to replace a reasonable facsimile. The income approach is designed to
calculate the market value based on the expected future income. And the market
data approach uses information gathered from recent comparable sales to determine
value.
The appraiser considers all three methods when making a
final determination as to current market value.
Comparable
Sales Data or “Comps”
In a weak market, it is difficult to use comparable sales
data to determine market value. Sales figures may not be available or may be
stale because properties aren’t moving. Prices, under these circumstances, usually
have no bearing on current market conditions. At best, comparables will give an
indication of trends.
A sample of comparable sales information from the CoStar
Group shows how the information is presented. Local real estate boards can be
of further assistance.
Gross
Multiplier Approach
The gross multiplier approach is the ratio between the gross
rents and the selling price. By comparing gross multiples of other properties
in the same general area, a rule-of-thumb determination of market values can be
made.
Capitalization
Rate Method
The capitalization rate is the ratio between the net income
and the selling price. This rate can also be compared to those of other
buildings in the same neighborhood. Capitalization rates should be adjusted to
reflect the following:
• Liquidity: How fast can you get your money out?
• Risk factors: What is the degree of safety?
• Tax benefits: How much money will you save on taxes and
when?
• Ability to borrow money: Is it easy to get loans on the real
estate
investment?
• Degree of management activity: How much time do you have to put into
managing your investment?
• Expectation of appreciation: What is the potential of this real
estate investment?
We generally don’t purchase buildings with a capitalization
rate under 8.5 percent. However, depending on the weight of these factors, we
would consider a lower capitalization rate. Adverse conditions cause the
capitalization rate to be adjusted higher; favorable conditions cause it to be
lowered.
Essentials of Real estate investment Analysis Software
Choose a computer program that fits your needs. You should
select software capable of providing the following features:
• Projections
and analysis of cash flows and tax benefits using the IREM
format
• Maximum forecasting flexibility
• After-tax IRR
• User friendly
A computer program that has these features makes it easier
to analyze properties. If the data is accurate, your reports will supply you
with the necessary facts to make the right investment decisions.
When inputting data, numerous assumptions must be made. There’s
an expression that communicates the importance of inputting good data. If data
submitted to computer operations came back stamped “verified,” it meant it was
accepted. Reports stamped GIGO meant the opposite! GIGO stands for “garbage in
garbage out.” The same applies to investment data. If the information inputted
is garbage, your out put will be the same.
The computer program should be designed to give an IRR based
on specific assumptions. Confer with your consultants to assist you in making
these assumptions. For example, estimates of tax rates and depreciation should be
made with the help of your tax advisor. When speculating on general business
conditions in the area, your real estate investment manager or real estate broker
should be consulted for advice. These professionals must be able to provide you
with the data needed to make the right assumptions.
ABOUT THE AUTHOR: Eugene E. Vollucci,
is considered to be one of the foremost authorities on real estate taxation and
investing and has authored books in these fields published by John Wiley &
Sons of New York. He is the Director of the Center for RE Studies, a real
estate research organization and President of calstatecompanies. To learn more
about the Center, please visit our web site at http://www.calstatecompanies.com
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