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.
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
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