The news has been saturated with reports about the financial bailout, the Secondary Mortgage Market, Securities and Derivatives. In these troubled times, it is important to understand the fundamentals of Real Estate analysis. There are a variety of models and tools that can help us better understand changes in market conditions and can even simulate probable ranges of value under different economic scenarios. I will be exploring how capitalization and yield rates provide the backbone of analysis in more detail in later posts.
All real estate investors, in one way or another, must incorporate the following four steps in their fundamental analysis & decision making process.
1. ESTIMATE THE STREAM OF EXPECTED BENEFITS.
Expected benefits include cash in the form of rent, depreciation, possible tax savings on other income, proceeds from the sale of the property (reversion), as well as other ancillary benefits. Make sure you project yearly changes in potential gross income, expenses, vacancies, capital growth and taxes using either a reconstructed operating statement or a pro-forma.
2. ADJUST FOR THE TIMING OF THESE BENEFITS.
$1000 received today is worth much more than $1000 received 10 years from now. Adjust for the timing of these benefits by using a process called discounting. If your time horizon is 10 years and you have purchased property solely for capital growth, then you had better be highly confident that the return you will receive through appreciation will be worth the wait and exposure to increased solvency risk.
3. ADJUST FOR DIFFERENCES IN PERCEIVED RISKS.
Real Estate is exposed to various forms of risk from issues in liquidity, interest rates, inflation, and economic growth, among others. However, Discounted Cash Flow models, sensitivity analysis, and simulation can give investors a handle on probable ranges in which an investment might fall in forms of risk management.
4. RANK ALTERNATIVES.
Different properties (or investments) should be ranked on perceived risk-return combinations. Additional financial returns should be rewarded for any added risk undertaken. Net Present Value can give us an indication of the total return of an investment in absolute terms while use of a Profitability Index can help analyst rank investments that differ greatly in overall cost and value.