Assumptions and their Importance in Real Estate Investing and value prediction

Dated: April 21 2019

Views: 167

A few days ago one of my agents sent me a text asking me what she should tell her client the appreciation would be at a certain condo project. I tried to think of an answer that I could distill into a brief text and came up with: “It depends on what she buys it for.” She finally called me the next day and we had a more substantive discussion. We talked about predictions and assumptions and the fact that the only the only time you control the price is when you buy.

Let me say this: If you are looking for a primary home you should be more concerned about whether the deal is good for you and your family, not appreciation. This discussion today will be more for second home buyer and investors.  By the end of this newsletter you will understand the assumptions that you must make that affect your investment prediction and enable you to forecast future value.

To forecast, we have to first understand how real estate is valued. There are three methods of valuation: The Income Approach, the Replacement Value, and the Comparable Sales Approach.

The Comparable Sales Approach is the one most often used in residential sales. The challenges in a swiftly changing market like we were in 2006-2010 (rapid drop in prices) and now in 2019 (a gradual decrease in prices) is that that the BPO is a snap shot, not a movie.  It looks back, not forward, although the price of the homes on the market is an attempt to anticipate future value, it is  rather unreliable.  The comparable sales approach ignores income and replacement cost and concentrates on sales of similar homes and offers a guess at what a particular home will sell for, adjusted for items like age, pool or no pool, garages, square footage, etc. in the current market.

The Income Approach is the landlord’s standard bearer valuation method. For the income and cash flow investor the questions are pretty simple; “What will the capitalization rate be on my investment?” (For an article that explains cap rates in more detail click here). Put simply, the cap rate is a measure of the return a property's net operating income will generate as a percentage of its cost. The income investor cares less about things like views and more about maximizing rent and keeping rental expenses down. For him it’s a question of cash flow and return on his investment.

The Replacement Value Approach examines current costs to build a similar building and until recently has been used mostly for insurance valuations. Normally boiled down to a cost per square foot to build and then adding extras like land and unique building features. Today I look a great deal at replacement costs. I use this as a bench mark for where the pricing must return in order for builders and developers to start new construction that will sell. In order for new homes and buildings to sell they must be perceived as a good value compared to existing opportunities. Today we can buy at prices that are as low as 30% of replacement costs.  To me this is a very strong buy sign.

Income versus Appreciation

One of many things that caused the bubble in the Florida real estate market is that investors were not looking at income valuation, but were banking, quite literally, on appreciation. If they used the income approach to valuation they would never have bought. They were using the comparable sales approach but did not understand what I call “the bigger sucker theory”. In the above paragraph about the comparable sales approach I mentioned that looking at the prices of other homes on the market was not a reliable method of predicting future value: and the bigger sucker theory is why. Many of the buyers in 2005 and 2006 that wanted to flip their acquisitions were counting on a bigger sucker coming along after them.  Oops.

Today smart investors look for the proper balance of income and appreciation.  My Asian investors call it benefit versus growth. If you keep your cash in a conservative financial vehicle you may achieve a 3% return. So a cap rate on a real estate above 3%; say 5 or 6% - COUPLED with an appreciation in value of 3 to 5% is an attractive alternative.

Let’s go back to the agent with the question to me about what appreciation would be on a waterfront condo. My short answer was that it depended on what she bought it for. That, of course is just the beginning of the question, but it is a very important first step. Investors like to buy “below market”. Many of the REO and foreclosed and short sale properties are acquired at “below market” because they are stressed sales, for cash, and with a very quick close. A more normal sale, with financing and time on market may bring an additional 10 to 20 percent in selling price.  This means first year value appreciation will be abnormally high.

Investors can also buy “below market” because there are fix up costs like air conditioning, plumbing, appliances and other repairs that a standard finance buyer cannot afford to undertake. They buy a home at 50% below market, pump in $15,000 and bam, the home is already worth 25% more than what they paid.

Unlike pre 2006, investors can today buy residential housing, including condos and single family homes, that will cash flow (the income will pay the debt). In the Boom Boom times this was impossible. A CAP rate of 2% might have been good. Today we achieve a CAP rate above the cost of borrowing money (currently below 6%).

As real estate professionals we have to be careful not to predict, indeed we CANNOT predict. But as investors we must make certain assumptions about cost of living increases, rents, and expenses in order to adequately determine an investment’s short, medium and long term value and return. With input from our investor, we can prepare a rather comprehensive forward looking document

In order to prepare this report we examine items like rents, taxes, insurance costs, and of course purchase price, and then build a model based on assumptions developed with the investor. We can also play “what if”  with different purchase prices, inflation rates, and appreciations scenarios.

Here are the assumptions that affect the report and the investment:

Purchase Price

Appreciation Rate

Vacancy and Credit Expense – we use 5 to 10% normally

Income Increase Rate

Expense Increase Rate

Other inputs like taxes, expenses, and insurance and maintenance costs are input based on historical data.

What this report will give you- BASED ON YOUR ASSUMPTIONS – is a return that combines both income and appreciation – sometimes calls an internal rate of return (IRR) based on SELLING the property at a specified date in the future. ( In this report we used 1,2,3,5,10, 15, and 20 year hold periods).

With a sit down I am sure we can help you with the assumptions and avoid the “garbage in, garbage out” syndrome. Please do not buy a property without a proper analysis like the one attached.

Today, in most of our markets, from Jacksonville to Lehigh Acres, in Orlando or Naples and Lee County, and certainly in the Sarasota market; our clients can achieve a good balance between income and appreciation. Keep in mind, straight appreciation plays (like land or vacant commercial buildings) are good opportunities as well in a down market that is rising and are also a large portion of what buyers are acquiring.

Blog author image

Gregg Fous

Real estate has been my passion since I took my first Al Lowery class on real estate investing in the 1970’s. I vowed during that class that I would buy one property a year. Over the next five ....

Latest Blog Posts

Should you buy now? Is it a Sellers market?

Should you buy now? Is it a Sellers market?April 17,2022First of all, I do not know you, your objectives, or your financial situation, and I am just a guy that loves real estate and writes about it

Read More

Get on the Escalator

 “BUY NOW, LIVE IN LATER” OR “GET ON THE ESCALATOR”                     07

Read More

Life Expectancy Chart for Florida Homes

InterNACHI's Estimated Life Expectancy Chart for Florida HomesThe following chart details the predicted life expectancy of appliances, products, materials, systems and components for homes in the

Read More

To me passive income is king; cash, not so much or for so long.

To be clear, I do not believe a housing crash is imminent, however there are some factors that are pointing to a crisis coming perhaps by the end of this year. This crisis may not be for you and me,

Read More