Pricing and Financing Real Estate Investments
Sure ways to go wrong in a real estate investment are to pay too much for the property and finance it incorrectly.
Pay the Right Price
The discounted cash-flow method is an effective way to estimate the value or asking price of a real estate investment. It emphasizes after-tax cash flow and the return on the invested dollars discounted over time to reflect a discounted yield. Software programs are available to calculate the discounted cash flows. You also can use Appendix Table A.2, as illustrated in Table 16.3.
To see how this method works, assume that you require an after-tax rate of return of 10 percent on a condominium ad vertised for sale at $200,000. You estimate that rents can be increased each year for five years. After all expenses are paid, you expect to have after-tax cash flows of $4000, $4200, $4400, $4600, and $4800 for the five years. Assuming some price appreciation, you anticipate selling the property for $265,000 after all expenses are incurred. How much should you pay now to buy the property?
Sure ways to go wrong in a real estate investment are to pay too much for the property and finance it incorrectly.
Pay the Right Price
The discounted cash-flow method is an effective way to estimate the value or asking price of a real estate investment. It emphasizes after-tax cash flow and the return on the invested dollars discounted over time to reflect a discounted yield. Software programs are available to calculate the discounted cash flows. You also can use Appendix Table A.2, as illustrated in Table 16.3.
To see how this method works, assume that you require an after-tax rate of return of 10 percent on a condominium ad vertised for sale at $200,000. You estimate that rents can be increased each year for five years. After all expenses are paid, you expect to have after-tax cash flows of $4000, $4200, $4400, $4600, and $4800 for the five years. Assuming some price appreciation, you anticipate selling the property for $265,000 after all expenses are incurred. How much should you pay now to buy the property?
Table 16.3 explains how to answer this question. Multiply the estimated after-tax cash flows and the expected proceeds of $265,000 to be realized on the sale of the property by the present value of a dollar at 10 percent (the required rate of return). Add the present values together to obtain the total present value of the property in this case, $181,097. The asking price of $200,000 is too high for you to earn an after-tax return of 10 percent. Your choices are to negotiate the price down, accept a return of less than 10 percent, hope that the sale price of the property will be higher than $265,000 five years from now, or consider another investment. The discounted cash-flow method provides an effective way to estimate real estate values because it takes into account the selling price of the property, the effect of income taxes, and the time value of money.
Financing a Real Estate Investment
Borrowing to finance a real estate investment is more expensive than borrowing to buy one’s own home, often 0.5 to 1.5 percent percentage points above the rate for customary homebuyers. There is more risk because the investor does not live in the property. The minimum down payment for investors is often 20 or 25 percent. Most investors finance real estate investments with conventional fixed-rate, fixed-term mortgage loans.
To make a smaller down payment and get a lower mortgage rate, some real estate investors buy a home, live in it for a year, and then rent it out as an investment. Another way to finance a real estate investment is through seller financing (or owner financing). This occurs when a seller is willing to self-finance a loan by accepting a promissory note from the buyer who makes monthly mortgage payments. No lending agency is involved. Investing buyers pay higher interest rates for seller financing. The seller may accept little or no down payment in exchange for an even higher interest rate, perhaps 11⁄2 to 21⁄2 percent above conventional mortgage rates. Owner-financed deals can be transacted very quickly. A popular way to start in real estate investing is to purchase sweat equity property. With this approach, you seek a property that needs repairs but has good underlying value. You buy this fixer-upper at a favorable price and “sweat” by spending many hours cleaning, painting, and repairing it to rent or sell at a profit.
Financing a Real Estate Investment
Borrowing to finance a real estate investment is more expensive than borrowing to buy one’s own home, often 0.5 to 1.5 percent percentage points above the rate for customary homebuyers. There is more risk because the investor does not live in the property. The minimum down payment for investors is often 20 or 25 percent. Most investors finance real estate investments with conventional fixed-rate, fixed-term mortgage loans.
To make a smaller down payment and get a lower mortgage rate, some real estate investors buy a home, live in it for a year, and then rent it out as an investment. Another way to finance a real estate investment is through seller financing (or owner financing). This occurs when a seller is willing to self-finance a loan by accepting a promissory note from the buyer who makes monthly mortgage payments. No lending agency is involved. Investing buyers pay higher interest rates for seller financing. The seller may accept little or no down payment in exchange for an even higher interest rate, perhaps 11⁄2 to 21⁄2 percent above conventional mortgage rates. Owner-financed deals can be transacted very quickly. A popular way to start in real estate investing is to purchase sweat equity property. With this approach, you seek a property that needs repairs but has good underlying value. You buy this fixer-upper at a favorable price and “sweat” by spending many hours cleaning, painting, and repairing it to rent or sell at a profit.
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