Home Company Profile Services For Sale/Lease Info Center Contact Us Info Center stClick here to read about the 2008 Commercial Real Estate Forecast Internal Rate of return - IRR The Internal Rate of Return or IRR calculation put simply measures the average annual yield on an investment. For an income producing property, the internal rate of return or IRR calculation uses the initial amount invested in the property, a series of projected cash flows which are usually after-taxes, and a projected After-Tax Sales Proceeds amount in a given year. Lets look at an example. If we were calculating the internal rate of return for an income producing property 5 years in the future, we would use the Initial Investment amount or the amount of money put down on the property, the projected After-Tax Cash Flows for each of the five future years and the anticipated After-Tax Sales Proceeds in year five, the final year, to calculate an average annual return on our initial investment amount over the five year period. The On Target real estate model calculates an After-Tax IRR in years 1 through 10 using this method. You should be aware of the following when using the IRR (internal rate of return) to measure the return on an investment. If in year 5, you have a return of 20 %, the internal rate of return calculation assumes that you made 20% on your cash flows for each of the five years. You may or may not be able to make 20% on your cash flows. The IRR calculation can therefore sometimes greatly exaggerate your average return on an investment. Gross Rent Multiplier - GRM The Gross Rent Multiplier or GRM is a ratio that is used to estimate the value of income producing properties. The GRM provides a rough estimate of value. Only two pieces of financial information are required to calculate the Gross Rent Multiplier for a property, the sales price and the total gross rents possible. If this information is available for multiple recent sales of similar types of income properties in a particular area, it can then be used to estimate the market value of other similar properties in that area. Some investors use a monthly Gross Rent Multiplier and some use a Yearly GRM. The monthly Gross Rent Multiplier is equal to the Sales Price of a property divided by the potential monthly rental income and the Yearly GRM is the Sales Price divided by the yearly potential rental income.      Example 1: If the sales price for a property is $200,000 and the monthly potential rental income for a property is $2,500, the GRM is equal to 80. Monthly potential rental income is equal to the full occupancy monthly rental amount which assumes all available rental units are occupied. Generally speaking, properties in prime locations have higher GRMs than properties in less desirable locations. When comparing similar properties in the same area or location, the lower the GRM, the more profitable the property. This statement assumes that operating expenses are proportionate for the properties being compared. Since the GRM calculation doesn't include operating expenses, this statement might not hold true for similar properties where one of the properties has significantly higher operating expenses.            Sales Price $200,000 GRM (monthly) = ____________ = ________ = 80            Monthly Potential Gross Income $2,500     Example 2: We have several similar properties that have sold recently in the same area and their average monthly GRM is 80. We can use this information to estimate the value of comparable properties for sale. If our monthly potential gross income for a property is equal to $3,000, we would estimate its value in the following way.            Estimated Market Value = GRM X Potential Gross Income = 80 X $3,000 = $240,000 A market GRM can provide a rough estimate of value, but it does have some limitations. The GRM calculation doesn't include a property's operating expenses and vacancy factor. We could have a situation where two properties have approximately the same potential rental income, but one property has significantly higher operating expenses. The above formula would result in a questionable estimation of the market value for these properties. Also, the above GRM formula uses the monthly potential rental income and doesn't account for a vacancy factor which could have an impact on the accuracy of the property value estimates. The seasoned investor understands the above limitations and uses the gross rent multiplier to get a quick feel for the potential market value of an income property. The GRM is sometimes calculated using the effective gross income rather then the potential rental income thus incorporating the vacancy factor in the GRM calculation. Effective Gross income equals potential rental income minus the vacancy amount. When vacancy rates are a factor, using the effective gross income will produce a more reliable estimate. The capitalization rate is a more reliable tool for estimating the value of income producing properties since vacancy amount and operating expenses are included in the cap rate calculation. The GRM is useful in providing a rough estimate of value. Appreciation - Real Estate Appreciation What is appreciation? Why do property values go up? Appreciation is the increase in value of a property over time due to inflation, supply and demand, capital improvements and other factors. Most real estate investors purchase income property for cash flow and capital appreciation. When weighing the benefits of purchasing a home or renting, many people opt to buy because they can increase their net worth via appreciation. The real estate investor should therefore have a good understanding of the factors that cause real estate to appreciate in value. Understanding why real estate goes up in value can help you make more profitable investment decisions. Properties appreciate in value for many reasons. The seasoned real estate investor will look for a combination of factors that will result in high appreciation growth rates Property values appreciate in value over time due to inflation. Inflation is caused by an increase in the amount of money in circulation. The value of money declines when the supply of money increases and the end result is increased retail prices. The cost of the land, construction materials, labor costs, building permits and fees, etc. go up over time making it more costly to replace an existing property. These factors alone do not guarantee that an income property will increase in value. Factors such as poor upkeep, the general decline of an area, economic obsolescence, reduced demand, increased crime levels, etc. can cause properties to decline in value even when replacement costs are increasing. In summary, personal residences and income property usually appreciate in value over time due to inflation because the cost to replace them has increased. You can increase the value of real estate by making cost-effective improvements. Improvements such as siding, a new roof, a new addition, new carpeting, landscaping, paint, etc. can increase the value of both personal residences and income property. Some improvements, dollar for dollar, will result in a greater increase in value than others. You should plan carefully and make improvements that result in the highest level of appreciation for the dollars that you spend. Keep in mind that if you make too many costly improvements, you might not recover those costs when you sell. Small improvements can sometimes deliver the greatest bang for your bucks. Supply and demand can cause the value of real estate to go up or down. Over supply can cause real estate values to fall and undersupply can cause prices to appreciate. Demand for real estate can vary greatly in different areas of the country and in different areas of a city. The demand for real estate is affected by the availability of jobs, the level of interest rates, availability of land, proximity to shopping, schools, parks, churches, etc., infrastructure improvements, population changes, desirability of an area, crime levels, property tax rates, zoning changes, etc. Are mortgage rates increasing or decreasing? The general level and the direction of interest rates can greatly affect the demand for real estate. As mortgage rates increase, the demand for real estate decreases and vise versa. Higher interest rates translate into higher mortgage payments for single-family home-buyers and inadequate cash flows for income property investors. Falling mortgage rates result in greater demand for real estate and faster appreciation. Over supply of a particular type of income property can result in high vacancy rates and reduced cash flows making it difficult for property owners to meet their financial obligations. The end result is lower prices. Ineffective property management and poor property upkeep can also result in high vacancy rates. Correcting managerial problems that improve operational efficiency and increase the bottom line can have a positive impact on the value of an income property. Be sure you understand your local real estate market place before you buy. You can correct a mismanagement problem, but you have little to no control when an oversupply problem exists. Is the job base in your community growing or is it declining? The availability of high paying jobs can greatly impact appreciation growth rates. If good job opportunities are available in an area, the demand for real estate will be high. People will move to the area to take advantage of job opportunities. The end result will be increasing real estate prices. The location of a property can affect how fast it appreciates in value. Water properties have been increasing in value at a fast pace. There is a finite amount of water property available in the United States and demand has been increasing. More and more people are reaching retirement age fueling the demand for recreational property. The proximity to recreation such as golf courses, cultural facilities, parks, universities and colleges can result in a higher rate of appreciation. Low property taxes can increase demand for real estate. Many areas of the country that have low property taxes are experiencing high population growth rates and high appreciation rates. Is the local economy expanding? Changes in the infrastructure of an area can have a large impact on the demand for property. Proximity to shopping centers, schools, hospitals, jobs, police and fire protection, public services, etc in most cases will increase the demand for real estate. An increase in infrastructure in a town or city usually translates into more jobs and greater demand for real estate. The smart investor will take advantage of infrastructure changes. Is the population growing in your area? Population increases usually translate into higher real estate prices. The demand for real estate in general has been increasing over time due to population increases. The population of the United States has been increasing every year. The amount of land is not increasing and the number of people looking to buy is. The level of new housing starts is a good indicator of the demand for single-family homes. If the level of new housing starts in a particular area of the country is high, home prices will likely be increasing. To understand the long-term picture, the investor should determine what is driving the demand and if will it continue. Note that the level and direction of interest rates have a big impact on new housing starts. Economic conversion which results in a change of use for a property can have a positive or negative impact on the value of real estate. Several examples of changes in use would include the conversion of apartments to condominiums, the construction of a restaurant bar in place of a commercially zoned personal residence and the conversion of a personal residence to a bed and breakfast. I have listed a few of the reasons why real estate appreciates in value. As a real estate investor, you should be looking for a combination of the above factors that will result in a high level of future appreciation. Be sure to take advantage of leverage to compound the affects of appreciation. Leverage is the use of borrowed money to increase real estate profits. You can compound your real estate gains by using leverage effectively. For example, you put $40,000 down on a $200,000 income property. It goes up 10% in value in one year. You have a gain of $20,000 and a before tax profit of 50% on your initial investment amount of $40,000.
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