Law Offices of Ronald D. Jackson

Real Estate

How to Evaluate a Real Estate Investment

Use a more strategic approach for your next deal.

Disclaimer: This is not legal advice.

Let's assume you are considering the purchase of an apartment building for $1.80 million. For a ten year period, you project that the building will generate the annual after-tax cash flows shown in the table below. At the end of the tenth year, you expect to sell the property. From the sale, you anticipate that you will receive after-tax net sales proceeds of $3.60 million. How do you evaluate the attractiveness of this potential investment?

Discounted Cash Flow Analysis and Internal Rate of Return (IRR) are key measurements often used to evaluate investment opportunities. Discounted cash flow analysis considers the time value of money while the IRR reflects your overall yield on the investment. The table shows your "net present value" and the "internal rate of return." The following discussion deals with how to evaluate the investment opportunity.

Let's take a close look at the interactive spreadsheet below:

Real Estate Investment
Year	$$$
10th Year $$$
10th Year Sale
Discount Rate
Net Present Value
Internal Rate of Return

Year 0 is when you will acquire the property and make the initial investment. The cash flow number is negative, because it reflects your initial cash outlay to acquire the property. Years 1 through 9 reflect the cash flows you expect the apartment building to generate (the numbers are positive because you're not anticipating any losses). Year 10 is when you expect to sell the building. Therefore, cash flow in Year 10 includes your expected cash flow from the property that year plus your after-tax sales proceeds.

What does the "discount rate" mean? The discount rate addresses the time value of money. It accounts for the fact that a dollar received tomorrow is worth less than a dollar received today. In other words, the rate is used to "discount" the value of money you expect to receive in the future to reflect what that money is worth to you today.

What discount rate should you use? One guide for deciding on a discount rate might be the mortgage interest rate that you can get on the property plus a risk premium for your ownership. For instance, if you can buy the building with a 7.0% mortgage and you add a premium of say 3.5% to cover your risk of owning the property, then you might use a discount rate of 10.5%.

What does "Net Present Value" tell you? The net present value or NPV tells you the extent, if any, that the present value of the money you expect to receive from an investment exceeds your investment. Stated another way: NPV = Your initial investment (represented as a negative cash flow) + the present value of your anticipated future cash flows, calculated using your discount rate. If NPV is positive, the financial value of your assets would be increased by that amount, and the investment is financially attractive. If NPV is negative, the financial value of your assets would be decreased by that amount, and the investment would not be financially attractive. If NPV is zero, then the financial value of your assets would not change as a result of the investment. You can compare the NPVs of prospective investments to determine which one is most financially attractive to you.

What does "IRR" tell you? The Internal Rate of Return or IRR is your overall yield rate on the investment. It refers to your average income or yield per year over the life of your investment. Don't confuse this with an interest rate; it is not your annual yield for any one year. It is your overall yield. It is an after tax figure and reflects the overall income or yield you earn averaged over the life of the investment. The IRR is all inclusive, because it considers your initial investment and estimated future after tax cash flows including sale proceeds after tax. In other words, it reflects both the return of your original investment and the return on your investment. How high does the IRR have to be to make an investment attractive to you? The answer depends on your goals. At a minimum, the property's IRR should exceed your cost of capital (e.g., mortgage rate).

Now let's play around with the assumptions in the interactive spreadsheet, and see what happens if ...

• You're able to negotiate a lower price for the property? Change the Year 0 payment from $1.8 million to $1.75 million. How does the lower price affect your IRR or overall yield on the investment? If you shaved $50,000 off the purchase price, your overall yield would increase by more than 3% (from 14.25% to 14.69%). As you see, savvy negotiation on issues of price and value can pay handsome dividends.
• You're able to give your lender a mortgage that has a lower interest rate? Remember, the mortgage rate is your cost of capital and should be reflected in the discount rate. So in addition to the lower purchase price, assume that you can shave a half point (.5%) off the mortgage rate. Assuming your risk premium remains the same (i.e., 3%), you should reflect your lower cost of capital by lowering the discount rate to say 10%. How does the financial value of this proposed investment now look in terms of NPV and overall yield (IRR)? The effect of a half point rate reduction translates into an additional $83,370 in your bank account ($652,796 NPV - $569,426 NPV). Smart negotiation, packaging and presentation of your proposed real estate deal are keys to your success.
• You're able to generate higher cash flows by lowering the property's vacancy rate? To reflect higher occupancy, increase the cash flows for Years 1 to 3 by 10% (i.e., change the cash flow in Year 1 to $165,000; Year 2 to $181,500; Year 3 to $184,800. NPV increases by almost $40,000 ($692,691 NPV - $652,796 NPV), and the overall yield from the investment is 15.02%. Careful preparation before you make your deal and smart management of your property can result in a very attractive return.

This article highlights basic concepts to evaluate a real estate investment. As you've seen, there are many factors to consider before you can really know if a particular transaction works for you. Sure, some successful investors may trust intuition, a strong market, or perhaps blind luck, but you can take the guesswork out of your next deal. A more discerning approach is possible.

Always remember: Price is important, but it's often not the most important factor in the success or failure of your project. The "terms of your deal" matter a great deal. The terms could mean the difference between earning a hard-earned profit for your family or losing money. It's easy to loose perspective during the emotion of a deal. To stay focused, know your goals and stay true to them. To get the best deal, you'll need objective insight and analytical skill on your side. For overall success in real estate, you'll need creative thinking, a customized plan, and most importantly — a strategic approach.