Real Estate Investment : One of the oldest investment classes

Real estate investment is one of the best and most profitable sources of investment in the long term. There are chances that equity investments may beat it due to the outperforming returns by many companies. But one can never ignore the fact that equity involves huge risks and real estate is a safer bet than it. Now what is real estate investment all about. It is not simply investing into a property and forgetting about it rather there is a complex structure attached to this investment class. The real estate sector is one of the most developed sectors in the previous decade and people who had invested in 2010 have become richer by almost 100 times today. 

Real estate investment involves investing into residential and commercial properties and even land for acquisition with a future prospect of better returns and constant income generation from it. Now there are three major types of properties one can invest into. They are residential properties, land & commercial estate. These are the major segments for investing in this class of asset. There are others as well which involve building the entire project or buying a project which is at halt or refurbishing a property. 

Benefits Of Real Estate Investment

There are many attached benefits to just ownership in regards to real estate property and investment. The best return is the constant generation of income through rent. The matter of fact is one does not invest his liquid investment into real estate. Hence they take loans from banks for such properties. This property is registered on behalf of the business entity so that the depreciation covers the extra profits. This gives the business side benefits. Now with ownership gained the property can be used for any purpose under law. This gives the right to rent it out for generation of money to pay the interest income. Yes the investors never pay the installments from their pockets. They plan to rent the property so that they can pay the interest through the rent generated.

The other benefit that is very obvious is the price appreciation over a long tenure of time. This means that when a property is bought the investor looks for a long time frame and hence it includes multiple factors like income estimation and expected return from appreciation of price. This attached two more things that are the locality to invest in and the development aspects of the area where property is bought.

Calculative Factors to Consider Before Investing

The major factors indicate Net Operating income and the income multiplier principle. Net operating income is the annual income generated after deductions of all the expenses and interest payments.

Now to begin the evaluation one needs to be sure whether the property is profitable to invest into or not. Capitalization rate is taken here into account for it. This rate tells whether the price at which the property is available is a fair price or not. We will understand the NOI approach and Gross Income multiplier valuation in another blog. Here let’s consider the capitalization rate for instance.

Capitalization Rate

The rate is calculated by taking the accursed future interest rates and risks associated with the property for getting an exact valuation. By this all the liabilities are considered and a fair price is calculated. 

For instance if a property has net operating income of 10000 Rs. The capitalization rate applied is 10%, so M.V. would be 

10000/0.10 = 100000 Rs. this is how market value is calculated. It equals NOI / Rate of capitalization.

How to Calculate Capitalization Rate ?

Now you would be wondering how is capitalization rate calculated. There are three techniques to do it. They are :- Build up method, Band of investment method and Market extraction Method. 

BUILD UP METHOD

Build up methods involves calculating liquidity rate along with price appreciation of property and risk involved. These estimates are found on the basis of the market conditions and location of the property.

Liquidity rate involves the factor of blockage of liquidity due  to buying off new property. This money could be invested in other sources. The Risks involve the exposure of property towards market changes. 

For Calculation let’s keep the liquidity rate at 4%, Appreciation recapturing at 2% and the risk involved at 3%. This sums up to 9%. In this we add the standard interest rate applied which is 7.5%. This gives us a rate of 16.5%. Hence the cap rate applied would be 16.5%.

Market Extraction Method

This method involves calculation on the basis of the nearby estimates. Suppose there are four lands adjacent to each other and they have their NOI plus Their market values Known. By this one can know about these figures and take an average from their numbers.

Suppose :- 

For Land 1 – NOI – 10000 Rs. / Market Value – 200000 Rs.

In case of Land 2 – NOI – 12000 Rs. / Market Value – 220000 Rs.

And For Land 3 – NOI – 17000 Rs. / Market Value – 300000 Rs.

By taking an average of these three assets – NOI = 13000 Rs. / Market Value = 240000 Rs. Hence the cap rate for it will be 13000(NOI) / 240000(M.V.)  * 100 = 5.41% cap rate.

Band Of Investment Method

This method involves the sinking fund factor (SFF)  along with the debt and equity proportions and their practice ratios. It is the amount that is kept on one side every year so that at the end in future period one has some money in hand. 

SFF = Interest rate / (1 + Interest rate)”n” – 1

Now lets assume that NOI of property is 1 Lakh Rs. and it is 50% equity and 50% debt ridden. The debt is valued at 10% interest rate for 10 years. The equity paid at an ROI of 15% per annum. 

So SFF = 0.10/ (1 + 0.10)”10″ – 1 which gives us 0.10/1.85 which gives us 0.54 approximately. This means the rate is 5.4% for SFF.  Now adding the SFF rate with interest rate the figure we get is 15.4%. (10 + 5.40).

So Cap rate here would be an average of both the equity and debt calculation. This gives us 

15.4 + 10 / 2 = 12.7% Cap Rate.

Hence Capitalization Rate is Calculated.

This is how we calculate the cap rate and hence it comes easy to analyse the real estate valuation and its feasibility.

CONCLUSION

The risks associated with real estate are tragic value degradation due to area degradation or less demand. There are various other generic factors as well. So this is how one should calculate the property before investing and take a wise decision.