Evaluating a real estate investment
By: J. David Chapman/January 4, 2024
As we enter 2024, many are considering investment options and some feel like real estate should be part of their investment portfolio.
I remind you that throughout history real estate investments have been one of the best hedges against inflation and inflation has been the ongoing theme of the past year.
As people are considering real estate, I thought this would be an appropriate time to ask Ryan Chapman, CCIM who is a Sr. Real Estate Investment Analyst for Capstone Companies, LLC to explain a few key indicators. Below is a summary of our conversation.
One of the common methods of evaluating a real estate investment is CAP Rate (Capitalization Rate). The CAP rate is a straightforward metric that provides a quick snapshot of a property’s potential return. It is calculated by dividing the property’s Net Operating Income (NOI) by its current market value or acquisition cost. The resulting percentage represents the expected annual return on investment if the property were purchased with all cash, without factoring in financing costs. CAP Rate is valuable for comparing properties and evaluating risk. Investors use CAP rates to compare different properties within the same or different markets. A higher CAP rate suggests a potentially higher return, but it may also indicate higher risk. A lower CAP rate is generally associated with lower perceived risk, often found in prime locations or well-maintained properties. Conversely, higher CAP rates may indicate more significant perceived risks.
A second evaluation matrix used is IRR (Internal Rate of Return). IRR is a more complex metric that takes into account the time value of money. It calculates the rate at which an investment breaks even, factoring in the timing and magnitude of cash flows, including both income and expenses. IRR represents the annualized rate of return an investor can expect from the property over the holding period. It is valuable for projecting returns an incorporating financing. IRR considers financing costs, making it suitable for investors who leverage their investments with loans.
A third popular evaluation is a Cash Return calculation. Cash on Cash Return is a metric that focuses on the actual cash invested in a property compared to the annual cash flow generated. It is calculated by dividing the annual cash flow (before taxes) by the initial cash investment, which includes the down payment and any closing costs. Cash on Cash Return is valuable for assessing cash flow and impact of financing.
– J. David Chapman is professor of finance and real estate at The University of Central Oklahoma (jchapman7@uco.edu)