Everyone likes to own a piece of land they can call their own. This can be as shelter or as increasingly the case is turning out to be as a worthwhile investment. Real estate would include homes, offices, retail spaces, parking lots, apartments, warehouses, etc. It is a tangible, immovable asset. Insurance and pension funds invest in real estate for a good rate of return. Mortgage-backed securities are real estate investment instruments. Countries too are investing in real estate. For example, China is purchasing condominiums, warehouses and retail spaces in America, quite aggressively.

There are different forms of Real Estate Investment:
<ul>
	<li>Free and clear equity</li>
	<li>Leveraged equity</li>
	<li>Mortgages</li>
	<li>Aggregation Vehicles</li>
</ul>
In the <strong>Free and Clear Equity</strong> form of real estate the owner obtains property rights for an indefinite time period. He can choose to rent or lease the property to a tenant. He can also resell the property to another party. This is also called fee simple.

<strong>Leveraged Equity</strong> is when the owner takes a pledge (mortgage) and a debt (promissory note) to relinquish ownership rights if the loan payments are made. Simply put a person investing in a piece of property takes a loan and offers the bought property as security to the agency he has taken the loan from. In the event of a default, the owner hands over his rights to the loan giver (usually a bank or housing finance agency). Leveraged equity therefore has two parts: equity ownership and debt. The mortgage loan therefore is made of the debt and the pledge.

<strong>Mortgages</strong> are also an investment vehicle by themselves. This happens in the form of mortgage-backed securities, the debt instruments that aid in real estate investing. In this format of investment, banks issue securities, in which a group of mortgages are clubbed together. Investors who buy these securities avail returns periodically, not unlike revenue streams from a bond. The components of this payment are net interest, net of mortgage servicing fees and a schedule of repayment of principal. If a debtor makes some early repayments on the loan, the debt holder also receives excess principal repayments called mortgage prepayments. This introduces some uncertainty in terms of the amount and timing of the cash flows.

In the<strong> Aggregate Vehicles form</strong> of real estate investment,<strong> </strong>investors invest with limited liability. It provides collective access to the investment. This is usually done through <em>Real Estate Limited Partnerships (RELP). </em>Limited liability means these partners are not involved in the management of the real estate, and only put in an initial investment. Capital is raised from a group of institutional investors brought together by an intermediary and are known as Comingled Funds. Payouts are made in the same proportion as the investment by each investor. These funds can be close or open ended.

<em>Close ended funds</em> have fixed closing dates. Post fund initiation, no new investors are allowed into the fund. No further reinvestments take place even as sales occur.

<em>Open ended funds</em> accept new investors and reinvestments even after fund initiation. These funds tend to review and change their portfolio over time.

<em>Real Estate Investment Trusts (REITS)</em> are a kind of close ended investment company. Their shares are traded in the market and they invest exclusively in the real estate segment. They are liquid investments but their share price can trade at a discount or at a premium to the Net Asset Value (NAV) of the properties in their portfolio. Unlike comingled funds, here capital is raised from individual investors. Since these companies invest in a wide variety of real estate, investors’ portfolios are diversified too.

REITS that invest in mortgages behave like an investment in a bond. There are equity REITS that invest in residential and commercial real estate using leverage and in this sense behave like a leveraged equity real estate.

The Different Forms of Real Estate Investments

Investing in real estate is not a simple decision. It requires mature investment taking capacities. Information inflow in the real estate market is complex. Investing in a company is far easier. Investing in a commercial building, however, has some complex plays in it. Real estate has certain characteristics that make it difficult to simply divide and invest in.
<ul>
	<li>Real estate is indivisible and immovable.</li>
	<li>One piece of real estate is only approximately comparable to another piece of property.</li>
	<li>Real Estate is illiquid.</li>
	<li>Lack of an international or national auction market. This makes the property difficult to assess.</li>
	<li>High transaction costs and management fees.</li>
	<li>Information about the real estate market is scarce.</li>
</ul>
To invest in real estate we take the intrinsic value of the property. We appraise a piece of real estate by estimating market value and investment value of a property. The market value estimate is independent, but the investment value of real estate depends on the intended use of the property by the investor. A real estate appraiser uses one or a combination of approaches to arrive at the property’s value.
<ul>
	<li>Cost approach</li>
	<li>Sales Approach</li>
	<li>Income approach</li>
	<li>Discounted after-tax cash flow approach</li>
</ul>
In this article, we take a closer look at the cost and sales comparison approaches:

<strong>Cost Approach</strong>: In this approach we ask the question what it would cost to replace a building in its current form. This seems a straight forward approach, but has many limitations. The first step is to undertake land valuation, which by itself is not altogether simple. Then we arrive at the cost of construction at current costs. More often than not, a property has other factors that make it more valuable. For instance, a commercial property with stable tenants of reputable brands in a good location can make it a landmark. On the other hand, an expensive to build property in a down market area, with high crime may not be perceived as a good investment.

<strong>Sales Comparison Approach</strong>: In this approach the value of the property is arrived at by comparing it to a benchmark. The benchmark could be a direct comparison to a similar property. Alternatively it could be the median or average of similar properties in transactions made at the time of appraisal. It is important that the benchmark account for any marked changes in market value of similar properties, correct and appropriate value of the benchmark is used, and it is ascertained that similar properties been sold recently, that provide an accurate benchmark.

When we discuss the sales comparison approach, we need to discuss the hedonic price estimation method as well. The characteristics of the property are identified first. This could include vacancy rate, age of the building, location, amenities, etc. For each property, each characteristic is given a numeric value, usually on a scale. This is done for each property that comprises the benchmark. These values are then regressed on their characteristic values. This results in a single reading for each property on the regression. The dependent variable is the transaction price and the independent variables are ratings for these characteristics. The estimated slope coefficients are the valuation of each characteristic in the transaction price. Therefore, each characteristic value has a corresponding monetary value. In this way a sale price is arrived at by using these characteristic values.

<strong>Example Using Hedonic Valuation Approach</strong>

Per Square feet, a real estate company follows the hedonic valuation approach to value houses in a specific area. The characteristics of property that affect its prices are listed below:
<table class="mytable" border="1" cellspacing="0" cellpadding="0">
<tbody>
<tr>
<td valign="top" width="160"><strong>Characteristics</strong></td>
<td valign="top" width="115"><strong>Units</strong></td>
<td valign="top" width="163"><strong>Slope coefficient in pounds per unit</strong></td>
</tr>
<tr>
<td valign="top" width="160">Number of rooms</td>
<td valign="top" width="115">Number</td>
<td valign="top" width="163">10000</td>
</tr>
<tr>
<td valign="top" width="160">Surface area of the garden</td>
<td valign="top" width="115">Square feet</td>
<td valign="top" width="163">10</td>
</tr>
<tr>
<td valign="top" width="160">Swimming pool</td>
<td valign="top" width="115">0 or 1</td>
<td valign="top" width="163">10,000</td>
</tr>
<tr>
<td valign="top" width="160">Distance to shopping center</td>
<td valign="top" width="115">miles</td>
<td valign="top" width="163">-5,000</td>
</tr>
</tbody>
</table>
The company wants to arrive at the valuation of a property that has six rooms, a 3000 square feet garden, a swimming pool and a shopping center that is three miles away from it.
<div class="formula1">

The value of Per Square Feet’s property is therefore:

Value = (10,000 x no. of rooms) + (10 x garden surface) + (10000 x swimming pools) – (5,000 X distance from shopping center)

Value = (10,000 x 6) + (10 x 3000) + (10,000 x 1)– (5000 x 3) = $85,000

</div>
The value of this property can be compared to other properties nearby based on the same characteristics.

&nbsp;

Real Estate Valuation: Part 1 (Cost and Sales Comparison Approach)

In <a href="https://financetrain.com/real-estate-valuation-part-1-cost-and-sales-comparison-approach/">Real Estate Valuation Part 1</a> we discussed the complexity of valuing real estate. <a href="https://www.viprealtyinfo.com/" target="_blank" rel="noopener noreferrer">VIP Realty</a> discussed two of four approaches of real estate valuation. They were the cost approach and sales comparison approach. In this part, we will discuss the Income Approach for valuing real estate.

<strong>The Income Approach</strong>: This approach treats the net operating income or NOI from the property as perpetuity. This perpetual stream is discounted at a market required rate of return and is known as the market capitalization rate or cap rate. Market cap rate is the rate that is used by the market in recent transactions to capitalize future income into a present market value.
<div class="formula1">

NOI= Gross Potential Income – Expenses (estimated vacancy, collection losses, insurance, tax, utilities, repairs and maintenance)

Appraisal Price= NOI/ Market rate cap

The market rate cap on benchmark transactions are:

Market rate cap= Benchmark NOI/Benchmark transaction price.

</div>
The benchmark here refers to a similar/comparable property, or the mean or median of many comparable properties.

The income approach assumes a constant and perpetual stream of income from the property. Inflation could impact the NOI over time in the sense that the NOI would grow at the rate of inflation. The market cap rate accounts for inflation. Since inflation is passed through, valuation stays unaffected. This is however not true for spaces on lease. Lease periods do not allow for inflation to be passed through on an annual basis. In the income approach all calculations are before tax, which is a limitation.

<strong>Example</strong>

A property holder wants to sell his apartment complex. He learns that a <a href="https://www.viprealestate.com/houston-commercial-real-estate.php" target="_blank" rel="noopener noreferrer">commercial building</a> and another apartment in the vicinity were recently sold. Using the income approach, the value of the apartment complex can be calculated as follows:

<img class="aligncenter size-full wp-image-4290" title="Real Estate Income Approach" src="https://financetrain.com/wp-content/uploads/2012/02/Real-Estate-Income-Approach.png" alt="" width="617" height="390" />

We use the actual cost and not financing cost when we calculate NOI. Depreciation is not deducted, assuming repairs and maintenance will keep the building in good condition.

Download the used spreadsheet from the below link:

<a href="https://financetrain.com/ft-members/spreadsheets/">Real Estate Valuation - Income Approach</a> - Provide calculations for real estate valuation using income approach.

Real Estate Valuation: Part 2 (Income Approach)

This approach is called Discounted After-Tax Cash Flow Approach. This method is used as a supplement to the other valuation methods, such as cost, sales, and income approach.

Under this approach, the investor calculates the net present value of after-tax cash flows from the property discounted by his required rate of return. For the investment to be worthwhile, the NPV of cash flows should be positive. Alternatively, the IRR should be higher than the investor’s desired rate of return.

<strong>Numerical Example</strong>

An investor is considering purchase of a property now and selling it after a period of 5 years. The details of the property and its financing are provided below.

<em><strong>Property Purchase Details</strong></em>
<table width="310" border="0" cellspacing="0" cellpadding="0"><colgroup> <col width="147" /> <col width="91" /> <col width="72" /> </colgroup>
<tbody>
<tr>
<td width="147" height="15">Property Purchase Price</td>
<td width="91"></td>
<td align="right" width="72">1000000</td>
</tr>
<tr>
<td height="15">Equity</td>
<td align="right">25%</td>
<td align="right">250000</td>
</tr>
<tr>
<td height="15">Required Cost of Equity</td>
<td align="right">12%</td>
<td></td>
</tr>
<tr>
<td height="30">Debt</td>
<td align="right">75%</td>
<td align="right">750000</td>
</tr>
<tr>
<td height="15">Debt rate (p.a.)</td>
<td align="right">8%</td>
<td></td>
</tr>
<tr>
<td height="15">Interest is Tax-deductible</td>
<td>Yes</td>
<td></td>
</tr>
<tr>
<td height="15">Straight Line Depreciation</td>
<td align="right">5%</td>
<td align="right">50000</td>
</tr>
<tr>
<td height="15">Mortgage Payment</td>
<td></td>
<td align="right">66621</td>
</tr>
<tr>
<td height="15">Marginal tax rate</td>
<td align="right">31%</td>
<td></td>
</tr>
<tr>
<td height="15">Year 1 NOI</td>
<td align="right">100000</td>
<td></td>
</tr>
<tr>
<td height="15">NOI Growth Rate</td>
<td align="right">10%</td>
<td></td>
</tr>
</tbody>
</table>
The property sale details are provided below:

<em><strong>Property Sale Details</strong></em>
<table width="217" border="0" cellspacing="0" cellpadding="0"><colgroup> <col width="151" /> <col width="66" /> </colgroup>
<tbody>
<tr>
<td width="151" height="15">Property sold after (Years)</td>
<td align="right" width="66">5</td>
</tr>
<tr>
<td height="15">Capital gains tax rate</td>
<td align="right">20%</td>
</tr>
<tr>
<td height="15">Sale Price (Forecasted)</td>
<td align="right">1200000</td>
</tr>
<tr>
<td width="151" height="30">Property Sale Expenses as a % of sale Price</td>
<td align="right">5%</td>
</tr>
</tbody>
</table>

<strong>Result</strong>

Using the Discounted After-tax Cash Flow approach, the NPV of this project is positive ($78,098). Therefore, the investor should invest in this project.

Real Estate Valuation: Part 3 (Discounted Cash Flows)

In developed countries such as US and Europe, there are real estate indexes that provide a measure of average returns on real estate investments. Other countries also have recently developed real estate indexes.

The returns from real estate consist of income and capital appreciation. Measuring the income from a property is easy but assessing appreciation is easy.

Real estate indexes measure return using one of the following two approaches:

<strong>1. Measuring Changes in Appraised Values</strong>

In this approach specialists appraise the properties periodically, typically once a year. An example index using this approach is National Council of Real Estate Investment Fiduciaries (NCREIF).

<strong>2. Using REITs as a Reference</strong>

In this approach the price appreciation is calculated by using REITS as a reference.  The total return is equal to income paid to shareholders plus appreciation of the REIT share price. Example REIT indexes are: The National Association of Real Estate Investment Trust (NAREIT), Dow Jones Wilshire, and MSCI.

There are also global indexes that are further broken down by regions and countries.

<strong>Adding <a title="The Different Forms of Real Estate Investments" href="https://financetrain.com/the-different-forms-of-real-estate-investments/">Real Estate Investments</a> in your portfolio</strong>

While considering a real estate investment project, an investor would analyze how the returns from the new investment correlate with its existing portfolio.

Many studies have suggested that real estate investments can provide risk reduction through diversification and protection against inflation.

Real Estate Portfolios

This video by Arif Irfanullah provides a very clear conceptual understanding of the alternative investments: real estate as a part of the CFA Level 1 syllabus. This video talks about:
<ul>
	<li>Forms of Real Estate Investment</li>
	<li>Valuation Approaches</li>
	<ul><li>Cost Approach</li>
	<li>Sales Comparison Approach</li>
	<li>Income Approach</li>
	<li>Discounted After-tax Cash Flow Approach</li></ul>
</ul>
<iframe src="http://www.youtube.com/embed/4VIgjCtNpPQ" frameborder="0" width="600" height="338"></iframe>

CFA Level 1 - Real Estate Investments

Real Estate Investments

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COURSE

Real Estate Investments

Lessons

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