The unique characteristic of our market forecasts is that we go beyond the traditional method of forecasting appreciation only to profile the income property return on investment for each market area. There are three basic components to return on investment with income properties. The first is value appreciation. The second element is leverage, since most real estate assets are purchased with financing. The third element is cash flow, which represents the impact of rent revenue, management fees, taxes, insurance, maintenance, and other costs associated with owning and renting an income property.
One of the key inputs into our return on investment model is the mortgage payment. Since income properties are not owner occupied, they typically involve higher interest rates than traditional mortgages. Our models assume a 6.6% interest rate in 2011 to build the return on investment estimates. Other key elements in the return on investment model is the closing costs, leverage ratio, and rent to value ratio. For most markets, our model assumes a 20% down payment and 4% of the purchase price in closing costs.
By profiling each market from the standpoint of its health for investors, we are seeking to provide insight that exceeds that of traditional reports from mainstream media publications. When evaluating income properties in a given area, it is important to understand that each market contains sub-markets that exhibit unique characteristics that can impact the return on investment for an individual deal. Our forecasts are intended to be overall estimates that are representative of an overall market segment, but will not necessarily represent every opportunity available.
Case-Schiller Market Predictions
The first twenty market predictions will center on the component markets Case-Schiller Composite 20 index. This represents the top 20 statistical metropolitan areas in the United States. One of the primary factors that many of these markets share in common is a generally high rate of taxation and regulation. The reason for this is because regulation and taxation both tend to be the most intense in densely populated areas. In addition to this, the valuation bubble that collapsed in 2008 drove up many of the top 20 metropolitan markets. The net result is a value contraction that is continuing into 2011 for many of the major market areas. Each market area has been evaluated for both its revised 2010 and forecasted 2011 value appreciation plus estimated return on investment for people who purchase an average property at the beginning of the year.
Supplemental Market Predictions
In addition to the component markets of the Case-Schiller Composite 20 index, we have chosen to represent a number of supplemental markets. These market values for real estate in these areas tend to fluctuate across a much more narrow band than the Case-Schiller markets. By and large, these markets did not experience the run-up in prices during the real estate bubble. This also meant that they experienced a much more mild value contraction. Return on investment in the supplemental markets is typically driven by cash flow to a greater extent than value appreciation.
The summary table shows 2011 value appreciation by market from CNN Money and Fortune magazine, along with an average of the two. Our market-specific ROI forecasts are built by using the average of CNN Money and Fortune, with the addition of our forecasted regression to replacement cost by market. These figures are all added together to arrive at the average appreciation rate, net of regression to replacement cost. In addition to this, the total forecasted ROI is listed for each market in the right-hand column. The table is organized with Case-Schiller markets in the top section and supplemental markets on the bottom. The external forecast information is color-coded to show value expansions in green and value contractions in red.
The overall trend for most markets is a slight recovery in 2011. Our models predict a general bottom for values in 2011, with many markets resuming a modest growth trajectory after three years of difficulty resulting from the financial crisis of 2008. One of the most significant effects impacting the 2011 ROI predictions is regression to replacement cost for many of our profiled investment markets. The genesis of this effect comes from the fact that values in many markets have become significantly disconnected from the cost of new construction or replacement cost. Some bubble markets with high land values have room for values to contract as land values deflate and other markets where foreclosures pushed values below the cost of construction have room to expand as values regress back toward the cost of new construction.
The ROI predictions for each individual market are based on three fundamental components. The first is component appreciation, which is based on a composite of forecasts from CNN Money, Fortune, and regression to replacement cost. The second impact is leverage. The reason why we separate appreciation from leverage is to pinpoint how much value is coming from the asset itself and how much is coming from the impact of leveraged financing to purchase the asset.
The final component of our ROI predictions is cash flow. This is a combination of research regarding market rents, relevant expenses, and mortgage costs including interest. Our models also have allowances built-in for vacancy and the cost of regulatory compliance. This has the effect of reducing the relevant rent for market areas with high vacancy rates and increasing the expense ratio in markets with older homes that require more maintenance and are unfriendly to landlords and will require higher expenditure to ensure compliance and process conflicts with tenants. When added to the impacts of appreciation and leverage, this provides a full picture of Return on Investment for each of the Case-Schiller markets and our handpicked supplemental markets.
Our model is one of the only places in the market where a full ROI build is conducted. Most forecast reports begin and end their analysis with value appreciation. However, we understand the full dynamics of return on investment and have chosen to build and report a complete ROI for each of the targeted market areas. With this in mind, we have created a comprehensive investment profile for 30 markets to empower people with the ability to make more educated and informed investment decisions. (Top image: Flickr | bark)
The Jason Hartman Team