Tuesday, April 19, 2011

Valuing Real Estate

Buying a residence or recreational property is usually an emotion driven purchase. A new residence is often chosen not based on economics but based on one's lifestyle choice. You may fall in love with the garage that also has a state-of-the-art workbench. Or the color of the wall paper is soooo pretty! This is the house you want to spend the rest of your life with – or at least the next 5 years. Oh ye unfaithful!

Emotional appeal is the reason that homebuyers pay too much for real estate when judged on the income potential of the place. Realtors typically do a Comparative Market Analysis (CMA), i.e. they compare what similar residences have sold for in the last 30 to 60 days in a particular neighbourhood. This has nothing to do with the economic value of a property and everything with the latest real estate market craze!

Appraisers do a similar evaluation, but they also may value a property based on its economic life and its replacement value. For an investor though, the 'income approach' is required. It typically values a property far less than a CMA and consequently many apartment buildings are selling significantly below replacement costs. There are different names for an income based evaluation. One name you may come across is the Annual Property Operating Data form or APOD. REIN, the Real Estate Investor Network led by Don Campbell calls it "Property Cash Flow Analysis". The evaluation of an investment is typically done following a two step screening process.

First properties are quickly screened for being in the 'Cash Flow Zone'. Does it create roughly enough cash flow so that the investor does not have to subsidize the rental operation? To measure the cash flow zone is nothing more than estimating the Gross Rent/Price Ratio. Typically if the gross annual rent is less than 8% of the property's purchase price it is not economic and the property is dropped as a potential investment.
Say a two-bedroom apartment brings in $1000 per month in rent. Then its annual gross rent is 12 x $1000 = $12000. Thus, as a first screen, the purchase price may not exceed $12,000/0.08 = $150,000. To find such a property in Calgary is, even in today's depressed real estate market, very hard. But that is the screen the property has to meet.

To find such a property the investor may have to review numerous listings on MLS or have his/her Realtor search for such properties. Realtors typically make much easier sales and better commissions when selling residential properties to home buyers. Many do not even understand the economic requirements of the investor. Neither do many have the patience to deal with investors. So you will have to be quite careful as to which Realtor is right for you. Don't just use your cousin or your sister's boyfriend's buddy!

After going through a hundred or so listings, you may find a property that makes it through your screen. Now you're ready to dig a bit deeper. It is time for your APOD. Some Realtors provide investors an APOD, but never forget that these guys and gals want to sell you the property! They often don't act in your best interest but rather in the seller's best interest. So treat such 'Realtor' adjusted APODS with a big shovel of salt!

Below is an example of an APOD spreadsheet. As REIN's Ray Reuter points out, the danger of spreadsheets is that it is so easy to do 'what if' evaluations. You tend to fill in overly optimistic numbers to justify a purchase price that is too high. There is here some serious judgment involved and you have to make sure that you don't put on a pair of rosy glasses because you're so anxious to buy.

 Here is the revenue portion of our APOD example. One two-bedroom apartment in NW Calgary build in the early 1980's typically rents for just over $1000 per month. If you're lucky (rose glasses?) you may rent the parking spot separately for an extra $35 per month or $420 per year. The total Gross Rent would be $12,840 per year minus vacancies. A 5% vacancy rate is pretty optimistic for the first year that you own a rental property, but over the long haul, once you become an experienced landlord it may be realistic. So that would mean that your Effective Rental Income is $12198.00 per year. Wow! A lot of dough! Really?

O yeah, there are expenses! Duuh!! In our example, we're dealing with a condominium complex so all external maintenance including that of the common areas is paid for from the condo fees. Also included in those fees is sometimes part of the utilities. In our case, water, sewer and heating are included in the monthly condo fees of $265. Not bad eh? Oops - $3,180 bucksos per year! Next are property taxes, $1069 per year! Landlord Insurance (building insurance is taken care off by the condo corporation and your tenants are responsible for tenant insurance) - $240 per year. Assuming no tenants trash the place, you probably still need around $300 per year for maintenance inside the unit (plumber, carpet cleaning, paint job, etc.) Oh, and your time or that of a property manager! In Calgary, I often forget about this because then I cannot find any property that makes the grade. Yet you really should take for this around 7% of gross rent or $852 per year. BTW land lording is hard work.

OK that is quite profitable, right? Since the tenant pays for phone, electricity and cable, our operating expenses are 'only' $4,789 and we're making $7409 per year! Eh… not so fast… what about financing? Typically we put 20 to 30% down on a property and the rest is financed through a mortgage. That way we get leverage. Say annual property appreciation of 4% (not counting 2008). So a $100,000 property increases $4000 grant per year in value. With 20% down, that would mean you make $4000 on a $20,000 investment or 20% ROI per year. Not bad eh? Plus rental profits! Yeah if all goes well!

So we need to pay financing expenses from our operating income of $7409. What kind of a mortgage can we get for that and still keep some pocket change? BTW, you better use that 'pocket change' to save for the occasionally trashed unit. A renovation can cost you easily between $7000 and $20,000. Where does that money come from? Well, this is typically not included in our APOD calculations but it is a real expense! Tenant screening is critical – we're in a business of nickel and diming as you may start to realize by now.

We have now reached the 3rd part of the APOD. If you 'paid yourself ' $853 per year for the time you spend on getting renters, collecting rent, calling plumbers, etc. your net operating income would be $6555.14 rather than aforementioned $7409. Your choice!

So suppose you end up paying $200,000 for a property that does not require any renovations and that is, what we call, rent ready. Add to that legal fees – say $1000 - and you put 30% down (my preferred down payment). Then a mortgage of $140,000 is required. With an interest rate of 3.59% (be realistic in your expectations some mortgages are more expensive than others) and 35 years amortization, your payment is $583.76 per month or $7005.18 per year. Ouch! Where are my profits? Yeah, you have to pay every year, if all goes according to plan $450 out of your own pocket! You're subsidizing your tenants and if things don't go according to plan… you are a lot more out of pocket!

The good news is that not all your mortgage payments go to interest. Part goes to paying off your debt – in our example you pay off close to $2049.76 annually. Thus overall you are making money on the rental operation. Now with one property you may not mind to pay out of pocket $450 per year. After all you're paying off the mortgage and accordingly you're making really around $1500 per year – or… only $120 per month.

Ahhh! Don't forget the annual appreciation (if it happens) of 4% in our example. That is greatly enhanced by the mortgage. In terms of profit over our $60,000 down payment you'd be making $9599.58 or 16%. But… with risk and a lot of hard work!

So would you want to pay $250,000 for this rental property? Your ROI would drop to 14% and you'd pay close to $2201 per year out of your own pocket – i.e. you're subsidizing the tenant. How many investments can you handle this way? 5? 10? Or none? REIN says that $250,000 is too much and $200,000 is marginal. A purchase price of $150,000 would provide you a ROI of 19% and every month $100 or so in your pocket (net cash flow).

How many 2 bedrooms do you see listed for $150,000? But that is what you have to pay if you truly want to make money on this property. Rental properties can be profitable but it is a lot of hard work. Are you a potential land lord?

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