Calculating intrinsic value is a fundamental requirement of value investing in the securities market. If the market value of a company is not sufficiently below its intrinsic value, then a margin of safety won’t exist which is required for a worthy value investment candidate.
This concept can be translated into the real estate market. We would define it as the property’s value based on prevailing cap rates using the stabilized net operating income (NOI) adjusted for prevailing market rents after your expected remodeling investment. This assumes that you are able to re-lease units that have been remodeled at market rates.
Most properties that sell for less than their intrinsic value are distressed either by their current ownership or their physical condition, or both. Generally the industry refers to foreclosure properties as ‘distressed’ because banks are not long-term owners and tend to be motivated sellers. They won’t hold a property for years but instead will discount it to whatever level is required to sell the property within a few months. These properties tend to sell at a discount to other similar properties that are listed for sale by owner-occupants in the market area. Too many bank-owned properties in a given market area will drag down overall market prices over time.
Properties can also be physically distressed by deferred maintenance, functional obsolescence (tiny closets, no master bath, etc.) or poor (or dated) design choices in finish materials, features and appliances. The best opportunities tend to be properties where the basic systems (roofing, plumbing, HVAC, electrical, foundation) are updated but design choices and finishes are poor. It’s always best to spend remodeling dollars on items that are visible to potential tenants and buyers and will create value either by commanding a higher rental rate or purchase price.
In practice, we look for the highest rental rates in a market area. After inspecting the property, we develop a remodeling budget including the ‘have to repairs’ on major systems and the ‘value add’ cosmetic changes that build value through good design choices in finish materials, features and appliances. We develop a projected basis (acquisition price + acquisition costs + remodeling costs) and then project cash-on-cash returns based on the increased rental rates.
Ideally we will see annual cash-on-cash returns of at least 4-6% during the holding period with an IRR of 8% – 10% including the sale proceeds.
In addition to calculating intrinsic value, we also like to look at several current property metrics to determine if we are getting a good deal including: price per unit, price per square foot and sale price. Is this sale price near the low end in the market area? While these metrics don’t determine if the property investment is a good one, it’s reassuring to see that your prospective acquisition is being done at the low end of current market values.