Operating Statement and Forecasting

09/16/2012

Investing in real estate is similar to investing in stocks. In order to profit from the investments, investors must determine the value of the property and predict how much profit they will generate. Accurately valuing real estate investment opportunities is crucial. There are several models and tools to use, but it is important to examine the investment from all possible angles. The market is often very uncertain, and any type of investment involves some degree of risk. Because of these things, valuing real estate investment opportunities is difficult.

One valuation used to estimate the attractiveness of a real estate investment opportunity is the discounted cash flow method (DCF). Future free cash flow projections are discounted using a cost of capital figure to arrive at the present value of the investment. If the calculated present value is higher than the current cost of the investment, it may be a profitable opportunity. Essentially, the DCF method is used to estimate the amount of money that would be received from an investment adjusted for the time value of money. The discounted cash flow method can be used to value just about any investment opportunity, and therefore is widely used. The article below discusses some advantages and disadvantages of this method.

http://www.investopedia.com/university/dcf/dcf5.asp#axzz279OwVfCK

According to the article, the main reason to like the DCF method is because it produces the closest thing to the intrinsic stock value. In general, DCF is a reliable tool that avoids the approximations and subjectivity associated with reported earnings. Discounted cash flow analysis helps investors identity where the company's value is stemming from and if the current stock price is rationalized.

DCF analysis does have its drawbacks. For one, the model is only as reliable as its inputs. For this reason, DCF prognosis can fluctuate wildly, depending on predictions and beliefs about how the market will unfold and the company will operate. In other words, if the free cash flow forecasts, discount rate, and growth rate are inaccurate, the fair value generated from the model will also be inaccurate and the investment could be over or undervalued. There must be a high level of confidence about future cash flows and other inputs. The model is also extremely sensitive to changes in assumptions and inputs. Any time these things change, the model must be reexamined because the fair value will also change. In addition, DCF is focused on long-term value, not short-term investing. The value derived from the model does not necessarily mean that the investment will sell for that value anytime soon. It could cause investors to miss short-lived price run ups that could be profitable. On the other hand, it could help investors from buying in to a bubble. The DCF model can also be fairly time consuming.

While the DCF model can help reduced uncertainty, it does not make it disappear. It is important to think through all the factors that will affect the performance of the investment.

The capitalization rate is also a good starting point to compare real estate investment opportunities and estimate the value of an income-producing property. It is essentially the rate of return on a real estate investment property based on the expected income that the property will generate, calculated as net operating income divided by total value as stated in the article below. The cap rate should not be the sole factor in any investment decision. 

http://www.creonline.com/cap-rate-formula.html

For more ways to value real estate, visit http://www.investopedia.com/articles/mortgages-real-estate/11/how-to-value-real-estate-rental.asp#axzz279OwVfCK

Supply and Demand in Real Estate

09/16/2012

Real estate economics is cyclical. There are booms and busts, rises and falls. Every year the housing supply is reduced by natural events, demolitions, and abandonment, while at the same time new housing goes up with construction and redevelopment. As mentioned in the article below, because land cannot be moved, it is a local commodity influenced by local conditions. Making more units take time, and there may not be room to develop more in a given area. When there is an over supply, lower prices are usually expected. On the other hand, a shortage in supply usually means higher prices. Although more real estate may  be in construction, the time delay is often too great to fulfill the demand and prices will rise.

http://www.thetruthaboutrealty.com/real-estate-supply-and-demand/

See the article and video posted directly below. To keep supply at a good pace, new construction should account for about three percent of the current housing supply. Anything about three percent could result in a bust, while anything below could cause a boom. The cost of construction often runs closely with the cost of real estate. For this reason, it is a good way to measure the condition of the real estate economy. As construction costs rise, the price of homes typically rises accordingly. Furthermore, as the cost of construction declines, further development is stunted.

Without buyers, the supply of housing is meaningless. Demand also affects the price of real estate, causing it to change as it fluctuates. Population affects demand in that as the population grows, supply is diminished and prices rise. Demand is dependent upon the purchasing power of potential buyers. There must be qualified buyers to have strong demand and meet supply. Typically, if disposable income rises faster than inflation, demand for housing should be strong.

http://www.thetruthaboutrealty.com/real-estate-supply-and-demand/

The video below discusses how foreclosures affect supply and demand. In general, and increasing number of foreclosures causes prices to drop. This is consistent with the law of supply and demand in that as supply goes up, demand goes down and prices fall. When foreclosures are decreasing as banks sell of inventory, prices will rise.

Real Estate as an Investment

09/16/2012

For many investors, real estate is more authentic than stocks and other types of investments due to the fact that it is tangible-- you can physically touch it. However, real estate investing is not black and white. As stated in the articles below, there are several ways to earn returns on a real estate investment, such as flipping a house or renting out an income property. Typically, a down payment is made and the rest is financed, creating leverage. With leverage it is possible to invest in more properties with less money down and capitalize on your investment. Similar to with returns on other securities, it is also possible to incur a loss if leverage is used incorrectly. 

http://beginnersinvest.about.com/od/realestate/a/real-estate-vs-stocks.htm

http://www.investopedia.com/articles/basics/09/real-estate-versus-stock-investments.asp#axzz26hBs9X1l 

Unlike stocks and bonds, real estate is relatively illiquid, meaning it is difficult to quickly convert to cash. See the graph below. In the long run, real estate values generally  increase at a steady pace. Stocks tend to be more volatile than real estate, but over the long run seem to have delivered much better returns. When investing in real estate, stocks, bonds, and other types of securities, there is an initial outlay of funds with hopes that their values will increase over time. Stocks are also more flexible and can be reallocated into different accounts. In many ways, stocks seem to be the better investment. It is often difficult to be diversified if investing in real estate. Investing in stocks allows you to own a piece of many different industries economy-wide. However, real estate does seem to be advantageous when it comes to stability and tax advantages. Real estate investment trusts can be used to combine some of the benefits of stocks with some of the benefits of real estate and assist in diversifying your portfolio.