- Investing in rental homes can be more challenging than buying apartment buildings.
- Metrics for home investments are not as clear cut as other real estate investments.
- The two Rs, Rent and Reversion, are key.
By Hilton Cohen
Special to InsideRealEstateNews.com
I believe in the maxim that you make money when you buy real estate.
However, in a seller’s market characterized by multiple offers and price appreciation, where is the limit of how much is too much to offer on a property?
While capitalization rates serve as a guide to buyers of multi-family properties, single family home investing is becoming a reputable institutional asset class without any income valuation mechanism. (A capitalization, or cap rate, is the expected return on an investment property based on the projected income generated by the property.) Buyers of single-family properties are instead subject to historical comparable sales data that largely reflects a homeowner’s intangible preferences.
I recently faced this dilemma when placing an offer on a single-family investment property that had a frenzy of showings and went under contract in two days to another bidder.
Following this experience, I constantly wonder how a higher valuation could be justified, without crossing the line into bubble territory. I think back to my University of Denver finance classes with Prof. Michael Crean, who drilled into my head that a property only produces two income streams – rent and reversion (resale).
The property that I lost has an outstanding location and the potential to create high rental demand after some value-add remodeling. I was comfortable with my offer after considering the return generated by rental income. However, it was my assumption regarding the resale value that would make or break the deal. As a conservative investor, I assumed minor capital appreciation.
I know what I thought the chances of price appreciation were, but how did my assumptions stack-up relative to other investors?
This brings me to the challenge of investing in single-family properties.
Unlike multi-family properties, in which competitive bidders have an income producing investment objective and an established benchmark for comparing price, single-family investors are competing against unpredictable owner-occupants, as well as other investors without any similar benchmark. A cap rate encompasses the dynamic return derived from rent and reversion. This provides a multi-family investor, who is confident of the rental assumptions, an indication as to the market’s expectation of capital appreciation.
Regardless of property type, determining resale price is pure speculation. The unknown leads to an increased level of risk. An ultra-conservative investor may assume zero capital appreciation. In that case, the full return needs to be generated by net operating income. Perhaps the question of how much is too much should rather be asked with reference to risk as well as to dollars.
Each investor has a predetermined return that they wish to achieve along with a desired holding period.
Understanding how much of the return is driven by rent and how much by resale is paramount to assessing an investor’s level of risk. An investment that is highly dependent upon resale value requires one to not only cash-out in order to realize the desired return, but to cash-out at the appropriate time.
How much was too much for me to offer on the property?
I was confident in my rental assumptions and could easily calculate the return generated by NOI. As this single-family investment was highly dependent upon capital appreciation for bridging the gap between my desired return and the return generated by rent, every additional dollar offered would expand the bridge.
An investor who understands their level of risk through partitioning the return between rent and reversion will know when to stop expanding the bridge by offering more money.
Hilton Cohen, who has a master’s degree in Real Estate & Construction Management from the Daniels College of Business at the University of Denver, is principal of Barjul Real Estate Management & Investment Services.
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