Estimating future sale price of property?

Question

Forgive me if I posted this in the wrong section, I couldn't find any other sections that seemed appropriate.
          
          I understand that when calculating either Net Present Value (NPV) or Internal Rate of Return (IRR), one must include the operating cash flow of each year. Additionally, the sale year must include the operating cash flow plus the cash proceeds from the sale of the property.
          
          Calculating the annual operating cash flow seems straightforward. The tricky part is estimating the operating expenses and an accurate vacancy rate. However it seems to me that with enough tenacity towards research, that information can be uncovered.
          
          The last cash flow year must also include the cash proceeds from the sale of the property in addition to the operating cash flow. What I am struggling with right now is understanding how one estimates the future purchase price of their property? What are standard methods used to estimate the purchase price of the property after X years?
          
          Below are a couple of my guesses but I would certainly appreciate it if anyone else can weigh in with their thoughts.
          
          1. Increase the purchase price of the property by X% depending on the average appreciation rate in that area.
          2. Extrapolate an estimated purchase price based on the operating cash flow of the sale year.
          
          Again, my question is how one estimates the future purchase price of their property? What are standard methods used to estimate the purchase price of the property after X years?

Jon Holdman · Answer

The short answer is there's no way to accurately predict future prices.

Historical, prices have been driven up based on inflation.  That required predicting inflation.  Then there are short term fluctuations.  Then there are local factors like a new employer arriving or an existing one closing down.

Bill Gulley · Answer

Hi, we have financial calculators, so let's use them.

Scott is correct in his approach to valuation as is Jon pointing out the unknown. However, the IRR is more properly used when the cap rate is known at the cost of capital. An economic or manager's rate of return is another matter.

This is interesting in that individual  real estate investors attempt to apply this type of financial analysis to residential or small commercial real estate investments as one might for the valuation of a captial investment or bond analysis. The economic value of a machine used in production can be easily idetifed based on it's capacity of output, operating expense and it's salvage value, all data based on large sample sizes and shown to be reliable over time. In a bond analysis, risk is assessed and idenitifed as an approximation based on partial differential equations (PDE) and then a yield over time with a present value or a strike price becomes a lognormal calculation.

As real estate investors we generally only use three variables to calculate the unknown. Factors that are generally ignored are timing of market conditions, maintenance, capital improvements, and the future market vaue of the property. The future market value of a property cannot be mathematically determined or defined because two important factors will not be known, that being the negotiating skills and the position or motivation of the parties in the transaction.

The IRR is the flip side of the net present value. What we generally due is instead of looking at an investment from a cost of capital or weighted cost of capital basis is to use a hurdle rate, an interest rate at which we demand a specific return. Requiring a 20% return is rather lofty in the financial arena. A capitalization rate which is above the cost of capital, what it costs to use money, is a financial or accounting profit, but it is not the economic profit.
The value of labor and management is ignored unless this ecominc cost is factored in the analysis. What is that worth? Should it be viewed at a market rate of what management and services would be over the period or is there another value acceptable on an after tax basis. As the manager of your investment, do you ever want a raise?

As Jon pointed out, there are unforseen economic factors that cannot be determined. His example being market driven primarily. Scott has pointed out a technical approach base on lognormal or constant variables. Jon has pointed out those factors that effect and limit Scott's approach in the analysis of the income stream over time.

My point is that the future market value is a guess. It is subjective. The capitalization rate or hurdle rate may or may not be valid. If you force a capitalization rate as a demanded return you have one valid, but artificial variable.The only other known value is the present value if you accept the asking price to begin with. The future value cannot be proven. This is over time, the longer the period of analysis the less reliable it becomes.

In the short term, estimations become more valid, market rental rates, capital expenditures, maintenance, management costs and a return for ownership can be reasonably identified and defined.

It seems that many investors attempt to solve such questions in the belief they can. Attempting to view real estate as any other investment and use a financial calculator to provide a result may only give a false sence of security.

The practice of real estate is an art as much a science. Real estate as an invetsment cannot be defined as easily as many other investments especially over time. In the reality of realty, as I like to call it, estimations of value must be based on experience, knowledge of the local markets, intuitiveness and an analytical approach based on comparable samples. A lognormal mathematical appraoch is simply not valid. Bill

Scott R. · Answer

You really cant predict the future sale price of a property, not very far in the future atleast, maybe 30 days, 6 months, ect. Problem being market goes up and goes down, your house might be worth $100,000 and all comps show $100,000 but if theres 5 forclosures in the neighborhood for $75,000 its going to be hard to sell yours for 100,000 even if its FMV. 
As far as commercial stuff, the value is based off the money it produces, but that is not guaranteed either, right now alot of people are lowering rental rates, which could effect the value of there property.
10% is generally a good vacancy rate people use, but all depends on your situation, if you have one unit and its vacant for 3 months your rates going to be alot higher, if its rented all year its going to be zero. On average, Id say 10% is a pretty safe bet in the big picture.  if you stick by the 50% rule you should be ok!
 -Scott

Rich Weese · Answer

Bill- at my age, every day I wake up is fun for me. Rich

Rich Weese · Answer

Joey- You got very good answers from those posts that said it is not possible to determine any guaranteed increase in property value. You look young, so from an oldtimer, DON'T worry about it. Just get in and time will take care of the rest. Good luck. Rich.

Rich Weese · Answer

I'm one that doesn't swear by the 50/2 stuff, and I've done very well. Different strokes for different folks. Rich

Bill Gulley · Answer

Hi, good morning, Rich, I'm in the old school as well, no rule of thumb, each deal stands on its own merit.
          
          Scott, cash flow is important, very much so, but the quaility of the property is even more important to me and to anyone who does not want the problems of a slum lord. There is a simple question to ask when you first consider a property...would I live there or work there? My first apartment was an older brick fourplex, not very fancy, but I was not ashamed to live there when I was a kid. That property has been maintained and is still functional today, with chariot parking in the rear! What you buy can be more important than a target profit on cash flow.

I look at a property in a three to five year window. That's over a period of time that I am rather certain of what my cost of money will be. Bill

Scott R. · Answer

Joey,
What are your goals? are you looking into long term rentals? if so you should look into the 50% and 2% rules, most people on this board swear by them, and I'd highly suggest trying to stick by them, which will be alot harder in california though. 
 Please let us know your goals and we will try and point you in the right direction, problem being if your buying to flip to an owner occupant, it doesnt matter how much it'll rent for, but if your buying for rentals, all that matters is cash flow, all depends on your goals!

Joey Wang · Answer

Thanks for the replies. I really appreciate everyone's input. It seems to me that there is a common answer: you can't accurately determine property price the longer the hold period. Additionally, trying to use cap rate to help aid in the estimation is fruitless since I will run into the same problem trying to estimate what the cap rate would be at that point in time.

Then it seems to me that when running through the numbers to determine whether a property is a good deal, I should not be focusing on trying to estimate the future property value to determine the rate of return in order to make my decision. Rather, I should use my own desired rate of return to drive my calculations and decision?

Estimating future sale price of property?

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