Evaluating Income Property

Income property is becoming more attractive to investors looking for a better return on their money. With today’s low interest rates, income-producing properties such as apartments and duplexes can produce exciting returns. As with any type of property, the value of income property is what someone is willing to pay for it. But, the main determinant of value for income property is the net income it will produce.

As we’ll see later, the income approach should closely correlate with the market value under normal market conditions. Buyers of residential income property will want to know the answers to several questions not normally asked by home buyers. First, what is the amount of cash flow the property will generate? Second, how much actual net income will it produce? Third, are the tax benefits that the property will provide the investor? Cash flow can be described as the amount of money collected as rental income each month.

This is the gross amount of money generated and does not consider expenses. Of course, cash flow is reduced when there are vacancies in the property. Net income refers to the amount of money left after all expenses are paid. Expenses include repairs and maintenance of the property, legal and accounting fees, taxes, insurance and management. When an appraiser evaluates income property, the rents at similar nearby properties are compared to the subject property. These rents are adjusted for factors relating to the size of the rental units, the overall condition and convenience to transportation, schools and shopping. Tax benefits should be ignored when considering the value of income property.

The tax law may change at any time and if you anticipate increased cash flow based on tax benefits, subsequent changes may produce severe problems. Appraisers don’t consider tax benefits of income properties since they vary from owner to owner. For example, the 1986 tax reform bill eliminated many of the tax benefits of owning income producing properties for certain investors. Some experts think the elimination of these benefits led to the decline in real estate values over the past several years. The most important consideration when evaluating an investment in real estate is determining the rate of return you can expect to receive.

Since you can put money in a C.D. and expect to earn about a 5 1/2% return, you would certainly want to earn a better rate for a riskier and more il-liquid investment such as real estate. Rates of return are computed on the amount of money invested. Typically, investment property requires a down payment of 25%, which would be the cash invested. The remaining portion of the purchase price would be financed by a mortgage. For example, consider an apartment building containing four two bedroom apartments. Say your purchase price is $160,000 and you put down $40,000. Assume the apartments can be rented for $600 per month, which translates to $7200 per year.

The four units would produce $28,800 in gross annual income. Now, consider the expenses. Conventional wisdom says that the units will be vacant at least 5% of the time. (This number could be greater in areas of high supply or low demand.) Five percent of $28,800 equals $1440 in vacancy expense. Other expenses include real estate tax, hazard and liability insurance, utilities, repairs and upgrades. As a rule-of-thumb, expenses run about 25 per cent of the gross income of smaller investment properties. When property management is required the expenses are closer to 30 per cent. And lastly, is the cost of borrowing. Assume the cost of a mortgage to be nine per cent. Total mortgage payments would be 9% of $120,000 or $10,800 annually for a thirty year loan. Below is a summary of how the transaction would look for computing a return on investment.

Cash down $40,000 $160,000

Gross Income $28,800 Less vacancy -$1,440, Effective Gross Income $27,360 Less Expense $6,840 Net Income $20,520 Less Debt Expense -$13,080 Cash Flow $7,440, $20,250 Pre-tax return on investment 18.6% with mortgage and 12.8% without a mortgage.

It is apparent that a much better return on investment ratio is achieved by borrowing instead of paying cash. This is known as leverage. When evaluating a specific income property such as the example, the appraiser will use the net income as a determinant of the value. This is achieved by assigning a “cap” rate and dividing this rate into the expected income. Thus a cap rate of.10 (10%) divided into the net income of $20,520 would indicate a value of $205,200 for the property. At a purchase price of $160,000 this property would appear to be a great bargain. A further word about “cap” rates. “Cap” is short for capitalization. The appraiser makes a judgment as to the rate of return on capital that is required in today’s market. That rate is used for a cap rate.

A few years ago when a higher rate of return was required, the investment property would be worth somewhat less. A 12% cap rate would indicate the property would to be worth $171,000, much closer to the purchase price used in the example. Cap rates are a function of interest rates. Thus, higher interest rates result in decreased property values because of the higher costs of borrowing. Income property values are influenced by many uncontrollable forces. In addition to the effect that interest rate risk and government tax policy have on the value of income property, competition can be ruinous.

In areas where new apartment construction attracts renters away from the older properties, only lower rents will keep tenants. And that will reduce your return on investment. During the 1980’s we saw competition sink even the best conceived office buildings and shopping centers when supply overwhelmed the demand. A landlord has little or no control over such developments and must be aware of changes in the market place. It might even be a good idea to get a new appraisal on income property every two or three years just to understand where things are headed. Knowing when to dispose of an investment is just as important as making the initial investment decision.