Ever wonder which metric is the best way to analyze a piece of real estate? Me too! There are so many to choose from. Cap rates, ROI, gross rent multipliers, net rent multipliers, leveraged rates of return, yields, etc., etc. ad nauseum. The problem I see with most of these is that they look at a snapshot in time for a given asset and don’t take into account increases or decreases in income over time.

Enter the realm of IRR or ‘internal rate of return’. The internal rate of return shows the rate of return over a period of time and takes into account variables in income over that period. Rather than looking at just one point in time, you get a picture of the return you should expect during your entire anticipated holding period.

Let’s look at a very simple example:

123 Any Street, Peterborough, Ontario is a hypothetical office building of 21,000 square feet with a projected first year net operating income of $105,000. Prevailing market cap rates indicate you should be looking at 8.5% as your ‘going-in’ rate. This puts a hypothetical value of $1,235,000 on the property (give or take a few dollars). Pretty simple, income divided by cap rate equals value.

What if you did some digging into the rent roll and discovered that one of the tenants, who occupies about 4,000 square feet of the building and therefore generates 19% of the net operating income, had a lease that was coming due in two years, and further that you found that they did indeed plan to move out at the expiry of their lease and have purchased land for construction of a new building two blocks away? That’s a significant drop in future income and therefore will have a direct impact on the value of the real estate today. A future event will have direct impact in the present.

As the new owner of the building there would be some period of time when the space might be vacant, and there would be some cost associated with releasing the 4,000 feet including: leasing commissions, build-out for a new tenant, advertising, etc. The series of cash flows over the first five years of ownership (assuming a sale at the end of the fifth year at a similar cap rate) might now look like this:

You can see that there is a substantial difference in the IRR of the two scenarios. This doesn’t mean that the property is a bad purchase, it just gives the investor a better picture of the real performance of the property and provides a more realistic idea of actual return over time. Other factors that would change this picture include things like: the effect of financing, rent escalations, economic factors, changes in future cap rates, and competition in the form of new buildings coming onto the market to name just a few.

If the IRR is within range of your expected rate of return then you can move onto doing more due diligence for the property. If it is well below what you expect, then you need to either negotiate a lower price, or keep looking for another property that does meet your investment criteria.

Have you ever used this method of comparison before? Did you find it useful? Let me know, I’d be interested to hear some real world examples.

Guest post by Doug Lytle

Century 21 United Realty thanks to Lynn Gagliardi and her team,
will again be entering a float in the Peterborough Santa Claus Parade
which is on Saturday Dec. 05/09 at 6PM.

The route is down George Street from City Hall to the Mem. Center and
our volunteers again will be collecting Canadian Tire Money
which is used for the Salvation Army Toy Drive.

If you cannot attend the Parade you can drop off your Canadian
Tire Dollars at ou office at 387 Gerge Street S.

Remember the need is greater than ever!

Is it time to jump in and buy an investment property. Depends on your
financial capacity and the type of property that you are looking for.

Residential and multifamily prices have not dropped in Canada like the United States or to the 30 to 40 % drop that alot of our stock and R.R.S.P.
portfolios did. The Canadian Real Estate Association has just revised their 
sales forcast up to 6.6% increase in unit sales and an average price to
$ 317,500
The Peterborough market is also up over last year and our unit sales at
Century 21 United are over forecast for November.
I would think that if there were more listings that the unit sales in Peterborough would be even higher.

THINGS YOU SHOULD CONSIDER
1. A real  estate Broker or Salesperson who has knowledge and experience
in the type of property you are considering. They will take the time to assist
in the ” Due Dilligence ” in selecting the right property for you and always
play the devils advocate as to why you should make an offer and why you should not make an offer on a particular property
2 Mortgage Broker. Your sales representative may assist you in finding the
right broker for you. A broker can offer many different ways and different
sources to find the best product for you.
3. Lawyer. You want a lawyer who specializes in Real Estate who can help
close the deal and assist with leases and general legal advice.
4. Accountant. If you don’t have an tax specialist now, get one to help
with finding you all the legal deductions that you can make.
5. Join an association. We have an excellent Landlord’s association
in Peterborough. The members are helpfull and knowledgeable and
will save you time and money.
6. Cash Flow. Years ago when I worked in the family construction
company one of Peterborough’s largest landlords told me his secret.
” Cashflow” Don’t  gamble on a capital gain to make it a good ” investment”
You have to have sufficent cash flow to cover the expenses and for maintenance and repairs. From 1991 to 1996 prices went down down down.
Good investment properties continued to provide a net operating profit.

Lets get started now before the spring market hits and you are competing
with more and more buyers.