May122010

The cash value of real estate explained

Most people purchase real estate in California because they believe they will get rich. Few want to spend money to provide a home for their family as most expect their home to provide money for the family. Houses are the new wage earners, not through rental cashflow but through appreciation. Life doesn’t work that way. Real estate can be a profitable cashflow investment, and it can make people rich — not through speculation on buying and selling, but through owning for positive cashflow.american gothic parody 200309

Cash value of real property

Establishing the cash value of real property requires an understanding of risk and relative rates of investment return. Today, we will review these basics and apply a little simple math to show how to value real estate based on its cashflow value.

Cashflow investment is very different than speculation. The value obtained from owning a cashflow investment does not come from the change in the assets resale price; the value comes from the cash the investment provides while it is owned. In contrast, a speculative investment derives its value from the change in resale price that presumably goes up. Sometimes speculative investments provide cashflow, but in the case of California real estate, speculative investments often have a strongly negative cashflow because people over pay and over leverage themselves in order to speculate.

Since a cashflow investment relies on positive cashflow to derive value, the investment is best analyzed with an assumed permanent holding period. Appreciation or depreciation is not considered as it is not important to the investment’s performance. Potential changes in asset value may be important if the investor needs to liquidate for other reasons, but a resale value at a later date is not a major consideration in analyzing the investment.

Also, since a cashflow investment needs positive cashflow to warrant consideration, the investment must perform immediately upon purchase. Once cashflow investors begin projecting future increases in rents to justify a purchase price, they are entering the fantasy world of speculation and failing to make a wise cashflow investment decision. Nearly everyone in California looks at property in this foolish way.

To properly analyze a rental real estate investment, the property must provide a minimum return in the first year of ownership without regard to future resale value. If rosy projections of the future occur, that is a bonus; if they don’t the investment is still likely to perform as planned. That is low-risk investing.

Equity and Debt

If you analyze nearly any property in coastal California, the capitalization rate (the measure of cash return) is very low, generally between 3% and 4%. With mortgage interest rates at 5%, such low capitalization rates are unwarranted. Why would anyone want to earn 3% in an equity position when they could invest in mortgage debt an earn 5%? Most do this because they expect rapid appreciation.

Equity should trade at a premium to debt. Just as a second mortgage carries a higher interest rate than a first mortgage, equity should carry a higher cap rate than debt because equity is a subordinate claim to real estate. Landlords must pay the mortgage before they pay themselves. If the mortgage is greater than the rent, the landlord loses money. Similarly, if the landlord sells a rental property, the debt is paid first, and any remainder is paid to the landlord. Given the subordinate position and the associated risk, smart equity demands a premium for subordination. One of the surest signs of overvalued real estate is cap rates that are lower than mortgage interest rates.

Of course, California speculators do not see it this way. Fools believe prices rise very quickly and go up forever, and they see debt as a tool that positions them to capture this appreciation. It works well during market rallies, but it is devastating when prices crumble — and prices do crumble because appreciation in excess of wage growth is not sustainable. Speculators chasing the dream of appreciation pay too much for real estate, and in doing so, they push cap rates down well below the cost of debt.

Advantages of equity

There are two main advantages of taking an equity position in real estate versus a debt position:

  1. Equity returns are perpetual because it is ownership. Debt can be paid off and retired whereas equity can be kept forever and passed on through multiple generations.
  2. Equity returns rise as rents increase with wage inflation whereas prudent debt is fixed. Adjustable rate debt may go up or down with interest rates, but it will never see steady growth like an equity position.

California speculators believe these advantages warrant paying a large premium to own real estate; however, overpaying for real estate reduces the return and negates much of the advantage of ownership. Premiums are not infinite.

The equity premium

When I say that equity carries a premium to debt, it is easy to get confused about what that means for pricing. For capitalization rates to exceed the cost of debt, prices must be low. Obtaining an equity premium means paying less for a property, not paying more. The relationship between the amount invested and the return on that investment is inverse; In other words, the more you pay, the worse your return and the lower your cap rate.

As a general rule, equity should trade at a 20% to 40% premium to debt. For instance, at 5% interest rates, capitalization rates should be between 6% and 7%:

5% x 120% = 6%

5% x 140% = 7%

Last week I profiled a cashflow property in Corona. The capitalization rate exceeded the mortgage interest rate and fell within the parameters listed above. That property is an excellent cashflow investment.

 

Cash value of real estate based on mortgage interest rates and monthly rent

Based on the relationship between debt and equity explained above, it is possible to produce a simple spreadsheet that relates mortgage interest rates and monthly debt to arrive at a properties cashflow value.

The table below is loaded with information. The two assumptions are the expense ratio which is how much of the income goes toward taxes, insurance, upkeep, and other expenses, and the other assumption is the equity premium I described above.

The first four lines show the calculation of net operating income from monthly rent. I have selected rents showing a range typical across properties here in Irvine. The columns to the right show the capitalization rate based on the mortgage rate as I described above.

The table itself shows the resulting cashflow value when you divide net operating income by the capitalization rate.

 

I imagine many who view these numbers in Irvine think they are rather quaint but completely meaningless. However, when you look at properties where values are not inflated — like the property in Corona — the numbers illustrate a basic truth about bottoming values in a real estate market. Once the equity premium over debt reaches a viable threshold, money is attracted to a market and prices are stabilized. Large swaths of Riverside County, most of Las Vegas, and much of the Phoenix markets are at prices consistent with positive cashflow valuations. In short, they are as cheap as they need to be for cashflow investors to come in an clean up the mess.

This doesn’t mean we are at the bottom in some of these markets because the huge supply of current and future foreclosures will continue to put pressure on prices, but cashflow investors will buy anyway because to them, if prices fall more, it is more reason to buy. Cashflow opportunities as good as what is currently available in Las Vegas are very rare, and cashflow investors are buying everything available.

I am very bullish on Las Vegas, not because prices will rise any time soon, but because prices are very attractive on a cashflow basis.


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