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The best way to develop a clear picture of the property and its potential is to examine all of the principal factors and then integrate them into a meaningful conclusion.
February 01, 2004 -- Buildings: An improvement should be judged by other structures of its own type, in relation to its location, and by its rental structure. Certain types of improvements, such as hotels, motels, bowling alleys, and restaurants, are not really improvements of real estate but parts of business enterprises. When you buy such a property, you are in effect, buying real estate, plus a business. In many cases, if the business does not work out, the existing structures cannot be used for other purposes and must be demolished if the property is to be put to some other useful purpose.
Gross Rents: The questions that should be considered here are: How competitive is the rental level, where is it headed, and what is a stabilized level? One mistake in this area is to assume automatically that the rental level is equal to the rental value. This is not always the case. The present rental level merely indicates what the present tenant is willing to pay for the premises. Premises rented at a bargain price in a good community have greater rental value than high-paying space in a declining area. Also, a poor apartment in a fashionable neighborhood will bring more than a much better unit in a middle income area.
Actual Costs: Here you have to estimate what problems will develop during your ownership. Actual expenses incurred by the seller may be less reliable than an informed estimate, since there is usually a wide variance from year to year in such annual expenses as maintenance, insurance and renting. Using a percentage-of-income formula is also not all that reliable. As a building ages, rents are likely to increase, while income is likely to decline. Your best guide is an educated estimate of the future expenses based on the information that is available.
Income After Expenses: Free-and-clear income is the best measure of real value--before a premium or penalty resulting from financing. One area to watch is earnings for the owner's services. The time and effort provided by the owner as well as the risk are factors that should be carefully considered when determining a capitalization rate.
Loans: When must the mortgage be refinanced? Will replacement be readily available? How will service on the amortized balance compare with current charges? Is it likely that new, increased financing will be available?
Equity: You should know the amount of equity cash that will be required when you acquire the property and in the future. The less cash you invest, the better the leverage and the lower the risk. Spreading your capital over several properties will permit the same dollars to control more real estate.
Tax Consequences: Low amortization (and higher interest) is great for taxes but not for refinancing. High land values hurt depreciation deductions but give the best opportunity for growth and stability.
Asking: It is a little better to pay a little more for what you want than to pay a little less for something that does not fit your goals.
Location: This, of course, is one of the most important factors of all. The desirability of a particular location is a constantly changing factor, and a judgment as to the present quality of a certain piece of property can be seen as part of an evolutionary pattern. For example, consider the following.
(A) A fully developed residential neighborhood has probably reached a plateau and is likely to decline.
B) A moderate-income residential neighborhood is more likely to decline than to improve.
(C) A strong retail or office district is likely to continue to improve unless it is challenged by a stronger district. |
