So today we’re going to lean into the numbers and take a look at two valuable metrics for evaluating income-producing real estate properties.
The first metric that we’re taking a look at, you’ve probably heard of before. It’s one of the most widely used metrics for evaluating income-producing real estate, and that’s the cap rate. So cap rate, short obviously for capitalization rate, is really all about the market value of the property and the income that it can generate.
So when we look at cap rate, we take the net operating income that’s generated from the property and divide that by the current market value. And the result is your cap rate.
The way to read a cap rate is the higher the income generated from the property versus the market value, the higher the cap rate. If someone’s looking to buy a property, you’re potentially looking for a property with a higher cap rate because there’s more income versus the price that you have to pay to purchase that property.
Inversely, if you’re on the sell side, you’re looking to sell your property at the lowest cap rate possible. Because that means you’re getting the most dollars in exchange for the property and the income that it generates.
One thing to keep in mind with cap rates is, typically, there’s a positive correlation between cap rate and the amount of risk you’re taking with the property. So the higher the cap rate, theoretically, the higher the risk for that property. But this is admittedly one of the areas where your market expertise can come into play.
Real estate markets are not efficient. Some will argue the stock market is efficient just due to the vast availability of information in the level playing field that happens there. But that isn’t the case for real estate. So if you are able to identify a discrepancy there—where risk and reward as defined by cap rate in this scenario aren’t in line—that’s where you can potentially identify an imbalance in the market and capitalize on that with your market expertise.
So there are four different ways that you can make money off of income-producing real estate. The first one is obviously income. Secondly, you have the appreciation of the property. Third, the tax benefits that are associated with real estate. And lastly, we have amortization, or debt leverage, being able to use a smaller amount down to purchase a property, take a loan out for the rest, but then you own the whole asset.
So that’s one of the downsides of cap rate is, really, we’re only looking at the current value of the property and the income that it generates. We’re not seeing those other three characteristics of rental real estate that provide value in the long run. That’s where we shift to other metrics to really see that full value.
So if you want to be able to evaluate all four of the ways that property can provide value in your overall financial plan, we really recommend taking a look at the APOD analysis.
APOD stands for Annual Property Operating Data. It’s a metric that was created by the CCIM, and really there’s a lot more that goes into it than a more basic cap rate, but the value of the output can also be significantly greater.
In order to generate an APOD analysis, you’re typically going to need a tax return. Some of the data that’s required to input into this type of analysis would be things like the leverage that’s being used on the property, the cost basis of the property, the depreciation, all of the expenses. Pretty much anything that you would see on a schedule of a tax return, that’s going to be inside of this analysis. It takes a lot more work, but we would argue that the work is worth it in exchange for that valuable output.
And what that valuable output is, is an IRR or internal rate of return. And this allows you to take a look holistically at the property and see that rate of return that’s being generated from all four categories—income, appreciation, tax benefits, and then leverage.
So it accounts for all four of those things. And then it allows for a little bit more of an apples-to-apples comparison to other real estate opportunities that you might be looking at or even other asset classes. If you want to compare it to stocks, bonds, REITs, whatever else you might be looking at, it allows you to do that far beyond just the income side that you can see with the cap rate.
And lastly, if you’re working with a financial planner, the data output from an APOD analysis can really help you incorporate that investment into your comprehensive financial plan.
So that APOD, the data that’s stored there—that allows your planner to input that data into their software, incorporate it in your overall plan, and help you make a decision as to if purchasing a property or selling a property is the right decision for you.
Anytime you’re making a financial decision, we believe that the more knowledge and data that you have available, the better. Our goal is for our clients to be making a confident and informed decision with each of their investment decisions. And when it comes to income-producing real estate investments, we think that the APOD is really the best way to do that.
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