Buyers want to pay no more than what they think others will pay for a property. Consequently, they converge on property valuations. However, investors differ widely in the discount rates they use. Consequently, a property purchased at market value can be an enormous bargain for the right buyer.
Overview
A multi-family developer client of mine is designing a 20-unit apartment. He hasn’t decided whether he’ll keep the building as a legacy investment or sell it in 10 years or so.
Here, the build quality decision is important. If he plans to keep the unit long term, then it may make sense to invest in more robust options. If not, then the standard design options are probably the most appropriate.
That probably seems obvious.
But it’s curious when you stop to think about it:
If high quality items are worth paying for when you build, wouldn’t they be worth paying for when you buy?
In other words, if they’re worth it to the builder, then aren’t they likely worth it to some buyer.
Afterall, if the math works, then the math works.
At first blush, those are some compelling lines of reasoning. However, the math can be different for two different real estate investors, even if they’re considering the same asset. Because of that, it’s possible that you can pay market price for a bargain.
I explained how that can happen in an email to the developer, which you can read here.
People Value Their Money’s Time Differently
Here's a walk through of how I'd look at the question; along with some background information to give context to the decision process. This answer is thorough. However, I think the scale of your investment warrants it. I've started with some basics in order to connect what I've written with what you already know:
The longevity of the elements and the structure will affect the return of an asset: all other things being equal, a structure with 30 years of useful life remaining is preferable to one with 10 years remaining. As such, an investor should pay more for a structure with 30 years of useful life remaining. In that way, the longevity of the structure affects return at resale.
The present value of cash flows (including the resale of the property) is one way to represent the complete return of a property. However, it is not the method most commonly used to assess the market value of a property, as discounting to present value requires an estimate of the time-value of money, and investors value their money's time differently.
On account of those differences, the present value of cash flows calculation may indicate that property A is preferable to property B for investor X, but that property B is preferable to property A for investor Y.
A Property Is Not Worth the Most That Someone Will Pay for It
Now, it might stand to reason that so long as a property provides the greatest present value based on at least one investor's discount rate, then that property would be worth that much (to someone).
Unfortunately, we have no way of knowing how a prospective buyer will personally evaluate the property. Whereas, the buyer does have some sense of how others (i.e. the market) are evaluating the property - and the buyer doesn’t want to pay a dollar more than the most anyone else will pay for the property.
To begin with, the buyer knows the bank's debt service ratio requirements (roughly, how much operating income the property generates relative to the mortgage payments), she knows the bank's financing rate, and she knows their equity requirements, she probably also knows how much most investors generally want to put down (currently, the minimum required amount). From the listing information, she knows the property's operating income. From that, he can calculate the most a property could cost if it were to allow investors to take the most common (i.e. the minimum) equity stake and still qualify for financing.
a property isn’t worth the most someone else will pay. It’s worth the most someone else thinks someone else will pay.
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The buyer can also triangulate what others are willing to pay for the property by looking at what others will pay for a dollar of income generated by similar investments. For example, by looking at the data she may see that a dollar of annual operating income from purely-functional residential apartments tends to sell for about $22.00. In other terms, a cap rate of 4.5%. (Aside: that cap rate gives her a lot of information: it summarizes the market's valuation of the non-income factors (appreciation, risk, etc.) that affect the value of the property. So even if she can’t find a perfect comparable, she can probably infer the subject property’s capitalization rate by looking at a basket of weakly-comparable properties.)
Ultimately, for the buyer's purposes, the market's valuation of these factors is what matters. After all, if the property is worth a certain amount on the market, then she will want to ensure that he does not pay substantially more than that amount for the property. Since other buyers are thinking similarly, in normal circumstances, the buyer will not need to pay more than market value, even if there is a very legitimate way that the property is worth substantially more than that to her.
the buyer doesn’t want to pay a dollar more than the most anyone else will pay for the property… even if there is a very legitimate way that the property is worth substantially more than that to [the buyer]
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In short, a property isn’t worth the most someone else will pay. It’s worth the most someone else thinks someone else will pay.
Market Valuations Cluster Around Certain Cap Rates
Now we can imagine how easily income relative to the cost of the investment (the cap rate) became the most influential metric: Assume that it is commonly known among investors that investors don't want to pay more for a property than other investors would. From that, we know that all investors know that all investors are looking for signs of what other investors are paying.
So any information that all investors know other investors have will be especially informative.
Historical records (sale prices and net income) are easily attained and widely accessible. Whereas there are, by definition, no records of the future. As such, figures that rely on speculation about the future, such as present-value of future cash flows, cannot be based on anything that all investors have.
At best, we can infer other investors' beliefs about the future from the records of what they have done (i.e. how much they've paid for a certain amount of income), but in that case, we're back to relying on historical records: sales prices and net income.
...both of the most relevant methods of appraisal are influenced by the capitalization method.
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That convention is further enshrined by lending practices. Banks require that buyers have a certain amount of equity, which is quantified in the loan-to-value ratio. The banks hire appraisers to determine the value of the property.
Appraisers use three methods:
- the cost approach,
- the market (or comparison) approach, and
- the capitalization (or income) approach.
The cost approach is based on replacement costs, which will necessarily be lower than the market value of the proposed structure anywhere where it is worth building. As such, the relevance of that method is controversial.
The comparison approach looks at the prices of similar properties.
The income approach uses capitalization rates of similar properties to estimate the value of the income provided by the property under consideration. The capitalization method is one of the two most relevant methods for income properties.
Moreover, the fact that the amount a bank will loan determines some purchase prices and the fact that that amount is, at least sometimes, determined by the capitalization method implies that the comparison method is influenced by the capitalization method.
Consequently, both of the most relevant methods of appraisal are influenced by the capitalization method. We should also note that discounting cash flows is not among the three most common methods.
Value to the Individual Is Not Value on the Market
So now we’ve established that the market puts a lot of weight on income relative to the sale price. We also touched on the fact that an investment may be more valuable to an individual investor than it is to the market.
Here I’ll use some scenarios to demonstrate how the value to the individual can differ from the value on the market. For simplicity, I’ll ignore appreciation of the land, inflation, change in rents collected and so on.
In this example, we assume the investor’s discount rate (or required rate of return) is 2.5% in our inflation-free scenario. (2.5% in zero inflation is about 4.0-4.5% in our low-inflation environment). In this case, spending more on the more durable structure makes sense.
Now, there’s an argument to be made that discounting treats cash that flows to future persons as less valuable than cash that flows to current persons, and as such, a person investing for a future generation should discount future payments less than he would if he were comparing investments he intended to make for his own benefit. (For simplicity, we’ll ignore the counterpoint that money this investor earns today could also be employed for the benefit of a future person.)
In other words, if the investor is interested in ensuring a regular long-term source of cash flows to a beneficiary (say his family) and not interested in how quickly wealth accumulates, then discounting future cash flows makes less sense. Accordingly, in this example, I assume the discount rate is equal to inflation (i.e. 0% in our zero inflation scenario).
For this investor, the case for investing in the more durable structure is abundantly clear.
Now let’s suppose that the investor isn’t sure that this investment will be his legacy investment. In fact, he believes he may sell it within 15 years.
We know that most banks want a 1.25 debt service ratio (i.e. net operating income is 120% of the cost of servicing the loan) and a 25 year amortization and that multi-residential interest rates are about 2% (the inflation-free approximation of current rates).
We’ll assume 35% down (a common requirement). In that scenario, a $90k property would require operating income of $3720/year and the $100k property would require $4,125/year.
As such, even if the investor paid a premium for a more durable building, the income it generates would not allow for the minimum down payment. A larger down payment shrinks the pool of potential buyers, which shrinks demand, and puts pressure on the price.
The property can support a $90k loan. Accordingly, we’ll assume the property is sold for that amount (again, note that, for simplicity, we’re not factoring in changes in the value of the asset overtime). In this situation, the less expensive less durable property makes more sense.
Now, even if the bank were willing to loan an amount that corresponds with a $90k valuation based on the income the property generates, that doesn’t guarantee that investors will pay that amount for the property.
Cap Rates Aren’t the Whole Picture
As discussed, capitalization rates are a useful way to estimate what other investors might pay for a property. We can do that by deriving capitalization rates from other multi-family properties. Below, I’ve included the most recent assessment of the capitalization rates commanded by Ottawa multi-family properties.
From that information we can see that investors will require properties to capitalize at a rate of 3.5%-4.75%/year.
Some of that variation will depend on the location and some will depend on the structure. Consider the following descriptions of Class A and Class B residential.
Other factors, such as the remaining years of the major elements (roof, boiler, windows, etc.) will also play a role in determining the price of the property within bounds set by the capitalization rates of the relevant alternatives and what the banks would be willing to lend.
Some factors will affect both, the income generated by a property, and the capitalization rate investors expect from that property. For instance, superior finishings are one of the criteria for class A status and they may also enable you to charge higher rents.
Now, this still leaves open the question of what options other investors value and how much they value those options. There are too many options to address here. However, I’m happy to comment on particular choices as you move through the process.
That said, in real estate, there’s a lot to be said for following the crowd and doing what others are doing. In many cases, they’re following best practices or they’ve converged on some optimum. Moreover, as a very general rule, unusualness crushes resale value.
So to your question of how I might evaluate different options, I would calculate the present value of the different scenarios.
- Identify the purpose of the investment and select a discount rate that is appropriate for that purpose.
- Establish the costs associated with your various options.
- Estimate the income from the property.
- Consider when you might sell the property.
- Estimate the market value of those options
- Estimate what the bank might lend on the property when you sell it and take the corresponding implied evaluation.
- Estimate what investors might pay for the property assuming it is built with the set of options under consideration and sold at the time you think you might sell it.
- If 2 is lower, then use 1 as your resale value; otherwise, use 1 or a figure not much greater than 1.
- Plug in the cash inflows and outflows (including cash outflows from acquisition, inflows from disposition, and inflows from operations) and compute the present value.
The option with the highest present value (PV) is to be preferred. If you are unsure of when you will sell it, then calculate the expected PV for each construction option. You can calculate the expected PV by calculating multiplying each of the possible outcomes (different sale dates) by the likelihood each outcome (sale date) will occur and then summing all of those values.
