Getting Back to the Basics In Real Estate Investments

Much has been written about the gloom and doom in the real estate market, but I’d rather focus on the opportunity that exists for the owner-occupant/investor willing to apply basic fundamentals.

We are readily aware of the decline in home prices since the peak in the late 2006 and early 2007 time period. Multiple Listing Service data supports that the overall median home price in Washington and Benton counties decreased almost 14.5 percent between the first quarter of 2007 and the third quarter of 2010. Households with employment and adequate income can now purchase a single-family dwelling at a very affordable price. Third quarter 2010 MLS data reflect the median home price in the two-county area to be $136,000. The present 15-year and 30-year fixed interest rates make the purchase opportunities even more favorable.

However, the keys in this scenario are households with employment and adequate income. The Fayetteville-Springdale-Rogers MSA is experiencing higher than normal unemployment; however, the area’s unemployment rate is listed as one of the lowest in the country. The preliminary November non-seasonally adjusted rate was reported at 5.9 percent. The latest month reported for the United States, December, reflected a non-seasonally adjusted rate of 9.1 percent.

We expect more stabilization in the housing sector in Benton and Washington counties later in 2011; however, we also expect there will be a continuing high level of foreclosures. Buying opportunities will exist for both the owner-occupant and investor. With respect to the investor, improvement in occupancy rates for single-family housing utilized as rentals, and multi-family housing results in this sector of the market being attractive as we enter 2011. The investor will need to apply basic real estate fundamentals in valuing these potential investments. Establish what the market rental rate is, as well as a realistic annual vacancy/credit loss. This results in a projection of annual income that you expect to receive from the property or properties. In appraisal terms this is referred to as Effective Gross Income. Then subtract operating expenses that you are likely to experience on an annual basis. This would include such potential expenses as real estate tax, building insurance, management, maintenance, etc.

There could also be a deduction for reserves for replacement of short-lived items. This would represent an annual allocation for later replacement of those items that have a life shorter than that of the building. Do not make annual expense deductions for depreciation, mortgage interest expense, or debt service. The type of lease will dictate what expense deductions you as landlord are required to pay.

After annual operating expenses are deducted from effective gross income, the income remaining is referred to as net operating income. This net operating income is then capitalized into value by use of a market-derived overall capitalization rate. This overall rate reflects both the return on, and return of, the investment. An overall rate can be abstracted from the market by dividing the annual net operating income by the sales price of the property. For the overall rate to be applicable to the valuation of your property, you would obviously want the properties to be similar, the sale arms-length and recent.

The preceding valuation methodology is fundamental to the income capitalization approach in real estate appraisal. It can be utilized in the valuation of most types of improved real property. It can readily be applied to the valuation of bulk single-family dwellings and multi-family properties, as well as improved commercial/industrial properties. In the 2005-2007 time period we moved away from relying heavily on a property’s potential income production in establishing value. We are now back to a real estate fundamental that has been with us all along. For the owner-occupant/investor that applies this model correctly, there are good opportunities available in today’s marketplace. These opportunities are present in both the residential and commercial sectors of the market. 

Tom Reed is a partner in Streetsmart NWA which produces quarterly reports pertaining to the residential, multi-family and commercial sectors of the real estate market. Company offices are located at 2804 Main Drive, Suite C, Fayetteville, Arkansas. The phone number is 479-575-9100.