Performance Measurement for Real Estate Investments
Accurate and reliable real estate valuations are difficult to obtain. As a result, gauging whether a property investment has turned out to be profitable is also not a straightforward process. There are a number of indices that an investor must keep a track of, in order to understand the current situation of their investment and make effective decisions accordingly. This article provides an overview about performance measurement in the real estate sector.
Why Performance Measurement is Difficult ?
Valuation of liquid assets such as stocks and bonds is easy. This is because they have a precise listed price. This price is quoted on an exchange every few seconds and anyone can transact at the quoted prices. However, this is not the case with real estate! Real estate prices are opaque and it takes significant effort and time to unearth both the rental and capital values of real estate. The true value of the particular property is only realized when it is the subject of a transaction.
Since all properties are unique (i.e. not homogenous), there cannot be a standard price in the market that is applicable to all investment units. As such, real estate investors have to look at a variety of measures just to find out whether the value of their investment is doing well! Here are some of the common ways that investors resort to in order to gauge the success or failure of their investments.
- Indices: Real estate indices provide a somewhat reliable way to measure the growth that has come an investor’s way. Real estate indices use the property prices of a given year as being 100. Then as the prices increase and decrease, the value of the index is changed dynamically. These indices reflect the property rates of different neighborhoods and the index captures the change in all of them reliably to a certain degree. Since this index is created by corporations who specialize in such transactions, the data provided is accurate and reliable. This makes indexes one of the most cost effective ways for investors to do back of the envelope calculations regarding the growth or decline in the value of their investments.
- Valuation: Another way for investors to find out the value of their property is by conducting a professional appraisal. In most countries of the world, there are professional appraisers who estimate the value of any given property very accurately and provide a report to the owners for a fee. There is a price tag attached to this service. However, when professional investors get valuation done for several properties, they can obtain a better price because of the economies of scale. Companies like Real Estate Investment Trusts (REITs) and financial bodies usually attach a certificate obtained from such appraisers as proof that the value of their property has appreciated.
- Comparable Properties: Last but not the least is the most common way to derive the value of a given property that is to look at the value of comparable properties. This method is easy to use and free. However, the results obtained as a result are not very accurate. This is because the prices of properties within the same area can also vary a lot. Factors such as amenities available in a particular house as well as its proximity to other facilities can influence the price range. Individual adjustments, therefore, need to be made for every property. As a result, the prices derived from such a valuation are inaccurate and cannot be used for any official purpose.
Measures to Look At
In case, the investor does not intend to liquidate the property but rather hold it for some more time, the investor can look at some of these measures to understand the performance of his/her investment better.
- Equity Growth from Appreciation: The main reason why investors put their money in real estate is capital appreciation. Therefore, the most important metric that such investors are interested in is, the equity growth that they have created as a result of holding on to their property.
Thus, these investors keep a track of their monthly mortgage payments which include interest as well as principal payments and then use the market price to determine whether or not the equity that they have built in the house is greater than the expense that they have incurred as a result of holding on to the house.
- Equity Growth from Cash Flow: Some investors buy properties not for capital appreciation, but rather for cash flow. They therefore deduct the interest expense each month from their cash flow. The balance is what contributes to their equity growth. Therefore, when this cash flow happens month on month, over a period of time a substantial growth happens. A lot of times, rising rentals ensure that the property creates a significant positive cash flow over time.
- Operating Ratio: Property investment is a long term game. Over a period of time both the positive cash flows generated as well as the operating expenses of holding on to a property both change. It is for this reason that a lot of investors prefer to keep an eye on the ratio between these numbers to gauge the effectiveness of their investment.
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The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
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