Real estate like stocks is an asset class, and some investment principles and valuation methods that apply to stocks also applies to real estate. In this article, I will look at some of the things that we should take into account when analyzing the investment appeal of real estate.

While it’s true that stocks generally provide investors with higher returns than real estate, there are situations where, if proper research is done and if bought at an attractive price, real estate can turn out to be great investments.Real estate is also a good source of passive income that can contribute to the spending power of retirees and allow them to enjoy their golden years more comfortably. Passive income generated by real estate investments can also allow younger people the freedom of not relying too much or at all on their jobs, and gives them a safety net to strike out on their own. Income from real estate assets can allow you to keep buying when the market is undervalued and everyone but the smart guys are selling.

Occupancy Rate

Whether you’re buying an apartment or investing in REITs, investors should look for a high occupancy rate. It is supply and demand; a high occupancy rate means that there is less rental space supply and this will increase the odds that rent can be raised successfully. For REITS, you can usually find the overall occupancy rate for a REIT’s properties in their annual report. For real estate like an apartment or a house in a suburb, investors should look at areas where houses are mostly occupied (if anyone knows how to check the occupancy rates for housing areas, please feel free to share, thanks).

Investors can also try and approximate the occupancy rate of their properties needed to make mortgage payments and cover maintenance costs. For example: A property investor might own 5 condo units, and need to rent out at least 2 units to break even on interest and maintenance costs.

Here are the steps I use to roughly determine the occupancy rate needed to breakeven for a REIT (This is assuming that majority of the REIT’s revenue comes from rental and not property management or etc):

Step 1: I find out the revenue that can be achieved at 100% occupancy. I assume 100% occupancy = max revenue and make the necessary adjustments with current revenue and current occupancy rate.

Step 2: I minus depreciation from total expenses.

Step 3: I express the expenses ex-depreciation figure in terms of a percentage of maximum revenue, and that percentage will be the occupancy rate I think is needed to breakeven.

Liquidity and Cash

Whether you own a few condominiums or have bought stock in a REIT, cash is important to protect you from adverse conditions where occupancy rates are low and rental yield is falling. If you own a few rental properties, you need to make sure you have enough cash to at least make mortgage payments and maintain your properties in case some of your tenants suddenly shift out. For REITs, I look for operating cash flow to be significantly higher than expenses.

REITs with high occupancy rates don’t need to carry much cash, as unlike individual property investors, REITs own many properties and have many tenants; this diversification of income sources reduces their financial risk in the event where some of their tenants decide to move out.

Mortgage

It’s important to lock in low mortgage rates whenever possible as any increase in the mortgage payments you need to make affects the returns you earn. But when mortgage rates are affordable but not cheap, investors may consider having a mix of fixed-rate and adjustable-rate mortgages on their investment properties, as this will allow them to enjoy overall lower rates if mortgage rates fall, and be somewhat protected if mortgage rates rise.

How conservative you are should also determine the type of mortgage you should opt for. Investors looking for stable income should get a fixed-rate mortgage and stably earn the difference between rent and costs every month. I personally will not take out adjustable-rate mortgages on my investment properties if I only have in my portfolio one or two properties, as the risk of lower cash-flows or even negative cash-flows due to an increase in mortgage rates is too much for me.

For a REIT, I look at the average interest rate of its debt, to see whether it’s acceptable or not.  I also look whether the REIT has a significant portion of debt coming due in the short- to medium-term, and if it can build up enough cash from now to then to finance the portion of debt coming due. I also find out how exposed the REIT is to increases in interest rates by looking at how much of their debt have variable rates.

Adding value

One of the ways REITs are able to add value to their properties is by renovating their properties to fit in more units they can rent out or increase the appeal of the malls to attract more shoppers which will be followed by the REIT being able to charge their tenants higher rent.

Individual property investors can also add value to their property investments. They can furnish their properties, build more rooms in their properties, or etc. What matters is that the investment made to enhance the value of the property results in higher rental income where the estimated additional rental that will be earned represents healthy returns on the value enhancing investment.

Valuing Real Estate

To value a property, investors should discount the estimated future rental cash-flows minus estimated future maintenance costs back to the present. If investors are looking for high returns and not just stable income, then the discount rate should be higher (I use 12%) than the discount rate of 6-7% that I recommend for stocks, as unlike stocks, rental income from real estate can’t grow much (increases in rental earned due to inflation don’t count, as you will still get the same purchasing power with your increased rental income; selecting good locations might result in long-term rental income growth that outpace inflation, but it will be more prudent not to take this potential growth into account).

After discounting back to the present the future net cash-flows the property is estimated to generate, we get a figure that’s almost the value we think the property should be worth. I say almost because we still need to add to the figure legal costs, and any other costs associated with acquiring the property. Investors should buy properties that are at a discount to the value the investors think they are worth.

The things I talk about in this article are by no means everything an investor needs to know about real estate investments, whether it’s buying shares in a REIT or buying real estate directly. For example: Investors planning to invest directly in real estate like a condo unit should also pay attention to things like location and etc.

I value REITs the same way I value stocks. Here’s my article on some of the things I look at when evaluating stocks for potential investment: Things I think about before making investment decisions