How to know if it’s a good investment? Part 3
The prudent investor takes an objective look at an investment property before they consider a purchase. For example, a multi-unit residential investment property I have for sale on Randolph Street in Napa has a seven-page spreadsheet full of data useful to a buyer in making an informed decision.
Before we dive into key investment indicators, let us discuss the cash flow model because you need the cash flows to arrive at some indicators.
The Cash Flow Model
In part one, we discussed the income and expenses of a property, which is generalized as the annual property operation data (APOD). The APOD is property specific.
We briefly discussed in part two how debt is not a part of the APOD and is therefore not used in calculating the capitalization (CAP) rate. However, debt is used in determining cash flow.
While the APOD is property specific, the cash flow analysis is ownership specific because it takes into consideration debt (loans on property), owner contributions (cash into the property to help float it), leasing commissions, funded reserves, and taxes.
The CAP rate is a good and quick snapshot of how an investment property performs compared to others (and other investments) the internal rate of return (IRR) is an indicator for specific ownership over a specific time.
Key Investment Indicators
In part one, we also discussed how we could take an objective look at different properties using the CAP rate, which allows us to compare one investment property to another.
The IRR takes the CAP rate one step further but is certainly not the only remaining indicator. The IRR is the most widely used because it represents not only the income and expenses of a property but also takes into consideration the nuances of the specific ownership over time.
In most cases, we would consider a property held for five or ten years, so the IRR analysis uses a discounted cash flow (DCF) model for these two periods. The DCF finds the value of an investment by estimating future cash flows.
You could consider the IRR as the “granddaddy” of indicators because it represents all the other indicators we have discussed rolled-up into one.
In essence, the IRR will tell an investor that at the end of a five or ten year holding period how their investment performed after they sold it for an assumed price.
With our Randolph Street property, the middle road before tax IRR is 24.14 percent. What this means is that if you were to purchase the property for $1.7 million, hold for five years with the assumptions of a three percent annual increase in rent and expenses, a loan of 75 percent of the purchase price, and you sold it at a three percent CAP rate you would have experienced an overall return of over 24 percent.
"How to know if it's a good investment," was an intense series of articles, thanks for sticking with me. Watch for my next article when I discuss the reasons your house did not sell at top dollar, if at all.
Burt M. Polson, CCIM, is an active commercial real estate broker. Reach him at 707-254-8000, or email@example.com. Sign up for his email newsletter at BurtPolson.com.