Real Estate investment analysis is little bit difficult than equity analysis because there is not any exchange for real estate properties nor any annual reports are published regarding to performance of properties.
Despite of having lack of means for investment analysis analysis of real estate whether commercial properties or house or factory space is possible.
In this post we are going to understand most important elements for real estate investment analysis.
Replacement Cost :
Replacement cost is cost of building same new structure again irrespective of market price of that property. This figure is mostly used by insurance companies for their claims and calculation of premium.
But this figure also have great relevance for real estate investment analysis. Although replacement cost does not give exact figure of intrinsic value rather it gives idea of relative cheapness in market.
If market value is far less than replacement cost of market then value is generally considered as cheap.
Replacement cost are less volatile as compare to market prices.
Great real estate investors like Sam Zell and Donald Trump has given great emphasis to this figure .
Suppose on 1 Jan 2018 a particular house is build and has market value of $6,000,000. Amount required to buy same amount of land and build same house equals to $450,000 then anyone will prefer option of building another house rather than buying present one . In short market are dear at this point. .
Now 1 Jan 2020 suppose there is economic slowdown and real estate prices fell sharply. Price of house mentioned above fell to $3,000,000 in this case replacement cost will more or less remains same (considering land value do not varies much). In this case it will be more preferable to buy already build house at $3,000,000 because it is cheaper options.
|Preferable To||Build||Buy already build|
In second scenario an already build house is worth less than brick, sand, labor, architect, cement and all other materials combined. This situation represent undervaluation in market which is assessed based on replacement cost.
One most important thing that is ignored when analyzing real estate is depreciation. Which must be taken into consideration at second step after doing replacement cost analysis.
Annual Income Calculation:
If you already have a property then construction cost and market value of land is not intrinsic value of property. Because once you do construction it becomes part of the sunk cost. Sunk Cost shall never be considered in any type of valuation calculations as this cost will have no effect on the property value or decision making because whatever financial decision you make sunk cost is not going to be recovered.
Then which is the proper way.
Value of any of its financial assets whether it is bond stock or real estate property is present value of future free cash flows which that asset is going to earn over the remaining life of that asset.
In case of real estate main cash inflow is rentals and insurance taxes repairs are some of major cash outflow we have to calculate net inflow of remaining life of asset and discount it to present value.
What is going to remain forever is land so add average market value of land of last three years(to avoid extremely high and low prices) to above calculated value free cash flows.
Annual installment to annual income ratio:
In order to be successful real estate investor you must know how to use leverage skillfully and for that I think Annual installment to annual free cash flows ratio is most important .
Take a hypothetical situation
You have been offered a house whose value is 10 million(5 million of land +5 million of construction) . Bank is ready to give 90 percent mortgage to value of property payable in 15 years . Annual installment to Free cash flow ratio is 1 which means your installment will be covered by income you earn on house.
In this case 1 million is all the money you have to pay and what you get is 5 million land after 15 years whose value will increase year by year and cash flows of remaining life of house after mortgage payment is completed.
Means more than 5X returns in 15 years. This is how leverage do its magic in real estate.
But in there will be very rare periods when you will get annual installment to Free Cash Flow ratio equals to one. But will be such opportunities time to time .
So this ratio helps in two ways. First is to find win-win deals second is to find out how expensive market in respect previous years.
Price to Earnings Ratio:
No matter whether you invest in stocks or property PE ratio will retain its relevance .
PE ratio must be calculated on net rental income and shall be compared with the historical records. One factor is not reflected in this ratio is increase or decrease in land value. Investors may adjust this in calculation if land value growth is steady and predictable but if it is too much volatile in nature then adjusting capital gains of land can give misleading PE ratio.
Normal growth rate
There are no stock tickers for properties so investors usually misunderstood what growth rate is to be considered as normal growth rate .
Say for Indian stock market we know that 10- 12 percent is normal growth . To find out same about real estate we have to fetch past date. During 2008 housing market bubble market had grown 86% in from 1998-2008. So normally 6-8 % can be expected normally from real estate properties. This is overall market figure if we segregate markets to small regions there are many opportunities create because of external factors like suddenly gaining business relevance, faster colonization where pieces of real estate in certain regions grow at much faster pace.
Also Read : How to do Industry Analysis
Market Value to mortgage ratio
As I said earlier in real estate leverage is very crucial. Flow of credit is not straight line but it moves in cycles. This cycle is called as Credit cycle. Because of this there are periods in market were credit flow is more so bank lend more money on house property with respect to its market value also there are periods in which there is credit crunch and banks are reluctant to lend in these periods bank take more mortgage and comparatively give less loans on it or for buying it.
When there is credit crunch real estate prices generally make lows as most of investors developers and homeowners buys house on bank loans . When low credit is available they either there is less amount of activity or postponement if decisions hence prices falls.
This can create great buying opportunity for those who are not dependent on credit.
With availability of data now many indices about construction cost and housing prices are published for each counties states and as per cities also. This provide great help for analysis of trends in real estate markets.
Some of Indices in India are
- Residex House price Index
- House Price Index (By Reserve Bank Of India.)
Underlying thesis of value with respect of prices will not change in Intrinsic value analysis for any of the financial assets whether stock bond or house. Warren Buffett also suggest to consider financial assets as bonds and income generated from them as coupons this will ease valuation process.