Learning What an Asset is Worth

One of the primary tenants of value-based investing decisions is the notion of “fair value” or “intrinsic value” of an asset.  This asset can be a company, or it can be an income property … the principals are the same in both cases.  As intelligent investors, the way that we generate exceptional returns is to know when the price of an asset in the market is trading below the true value of that asset.

This begs the natural question of how to determine fair value.  In the case of valuing a business, one method is to determine the “liquidation” value of the assets and compare it against the market capitalization plus outstanding debt to determine if it represents a superior value.  Another common method of company valuation is to view the Operating Income (or Earnings Before Interest and Taxes) and determine an appropriate value multiple to compare against the market price.  There are many other metrics that value investors use such as comparing a valuation multiple (Such as a Price to Earnings Ratio) against the growth rate of earnings.

In the case of valuing income properties, these techniques can still be used, but they must be adapted from the context of business valuation to property valuation.  Three principal methods of valuation for Income property provide the basis for value-based analysis of income property as an investment.  These methods are: Replacement Cost Analysis, Rent to Value Ratio, and the Area Population Trends.

1. Replacement Cost Analysis
   1. The first and most basic question that an income property investor should ask is how the purchase price of the property they are buying compares against the construction cost to replace that property.  The reason for this is because properties in a healthy market tend to regress toward replacement cost plus the cost of land.
   2. When purchasing a property below replacement cost for the area, you are making a bet that the population trend will hold constant or increase, and push prices up to the cost of full replacement.
   3. When purchasing a property above replacement cost for the area, you are making a bet that the fully burdened replacement cost will escalate up to and beyond the point where you purchased.
2. Rent to Value Ratio Analysis
   1. The Rent to Value Ratio is calculated by comparing the monthly rent (net of vacancy) against the market value of the property.  This ratio tells you the gross monthly income generated by the property for the purpose of paying expenses and generating cash flows.
   2. The advantage of this metric is that it is not distorted by differences in management costs, tax rates, or financing terms between property markets.  It simply articulates the gross monthly cash yield of an income producing property.
   3. It is very important to use realistic assumptions when creating a Rent to Value Ratio.  The reason for this is because many blighted markets have what appear to be fantastic opportunities to purchase properties at low prices.  The theoretical rent to value ratios in these markets can be gigantic until one factors in the likely vacancy, which can be very high.  Rent can only be collected from tenants who are both living in your property and able to pay.
3. Area Population Analysis
   1. The purpose of Area Population Analysis is to determine the trend of people moving in or out of the surrounding metropolitan area, and the ease with which the supply of housing can expand to accommodate a rising population.
   2. The importance of this analysis is to determine the degree to which prices can be expected to regress toward replacement cost.  In areas with net population decline, prices can persist far below replacement cost for a very, very long time.  The reason for this is because a declining population means that the supply of housing will exceed the demand out into the foreseeable future.  There will be no reason to start new construction since existing property can be purchased from banks at foreclosure prices well below the cost of construction.
   3. In addition to this, Area Population Analysis should assess the ease with which new supply can be added to the market.  In market areas where it is easy to build, investors should not expect to see continued escalations in the cost of construction.  Conversely, in markets with very tight building restrictions and limited buildable area, it is likely that the replacement cost of property will escalate rapidly.

What these analytical techniques give us is a way to “triangulate” the intrinsic value of an income property for the purpose of determining whether to invest.  Another common method of Income property evaluation is the “Cash on Cash” return, which analyzes the forecasted net cash flow as a percentage of the total cash invested.  The advantage of this method is that it provides a metric of value that is very specific to the particular deal being analyzed.  The disadvantage of “Cash on Cash” analysis is that it is highly influenced by the terms of financing and tax situation of particular investments.  This makes it very difficult to compare properties against one another in an objective manner.  Similarly, property evaluations that build tax savings and appreciation into the forecasts tend to be very individualized, and make comparisons across properties difficult to do in an objective manner.

As Intelligent Investors, we should be evaluating our purchase decisions based on the “value equation” of replacement cost, cash yield, and area trends.  It is very unlikely that we will be able to find many deals that are exceptional in all three of these categories.  The analytical process is all about valuing the trade-off’s to determine if our investing decisions are intelligent or foolish.