Our main goal with Open Avenue is to make real estate investment easy and transparent for any type of investor so that anyone can value real estate.
Real estate is a valuable diversification tool for your investment portfolio given the fact that direct-owned real estate has a very low correlation with the public stock market and tends to remain steady when the markets are not.
Real Estate Valuation Made Simple
A property generates revenue through tenants paying rental income each month. There are expenses incurred in order to operate the property - property tax, utilities, insurance, regular maintenance, and administration.
When the rental income exceeds operating expenses, a profit is generated, and this is why real estate has value. Since this profit will be generated year-over-year indefinitely assuming the property is well maintained and rental demand continues, we can determine the value of this income stream by multiplying that annual income a certain number of times to arrive at the property value.
So let's be clear - the property value is simply a multiple of the annual income of the property. And the annual income is simply the rental income the minus operating expenses. A more technical phrase for the annual income is the Net Operating Income or NOI.
A more common way to represent the multiple is to use its inverse, known as the Capitalization Rate (or "cap rate"). If a property is valued at 10 times its Net Operating Income, then the multiple would be 1 / 10 or 10%. Intuitively, it would take 10 years for your annual income stream to return the full value of the property back to you.
What determines the multiple or Capitalization Rate?
Simple market forces determine what cap rate a property may be valued at.
Real estate investments are compared based on their cap rates, or how long it will take for the income stream to pay off the value of the investment. Since rental income and expenses can vary year over year, properties with better long term prospects (ie. good location) will demand a better (lower) cap rate from investors because they might be viewed as having less risk.
What about the mortgage expense?
You may have noticed that the mortgage cost wasn't listed as an expense when valuing real estate. Mortgages are not an operating expense and have nothing to do with the value of a property. Mortgages are used as a tool to acquire a property without paying for the entire property up front. This is known as leverage. Many investors will take their Net Operating Income and use it to pay off a monthly mortgage in order to leverage their returns. In a future article, I will go into detail on how leverage can affect real estate investment returns.
Posted by Tim McKillican