Real Estate/Property Investment

These are businesses that buy real estate property as income generating investments. One of key succes factor in real estate investment is correctly valuing the asset itself. The common way of valuing real estate is to value each of the properties and to aggregate them. Once you know where are the under valued properties, you can effectively decide where is asset to be bought. At the opposite, knowing real value of real estate also help you setting the price strategies apply to your assets. However, a premium may be attached to this value, if a business has shown the capacity to repeatedly buy under valued properties.

The factors we should think about when valuing real estate businesses are the same factors we think about in any valuation – the capacity to generate not just cash flows but also excess returns and the uncertainty associated with these cash flows. The valuation models developed for financial assets are applicable for real assets as well. The value of real estate property should be the present value of the expected cash flows on the property.

Real versus Financial Assets

Real estate and financial assets share several common characteristics - their value is determined by the cash flows they generate, the uncertainty associated with these cash flows and the expected growth in the cash flows. Other things remaining equal, the higher the level and growth in the cash flows and the lower the risk associated with the cash flows, the greater is the value of the asset.

To use discounted cash flow valuation to value real estate investments it is necessary:
- to measure the riskiness of real estate investments and to estimate a discount rate based on the riskiness.
- to estimate expected cash flows on the real estate investment for the life of the asset. The following section examines these issues.

Risk in Property Investment

There are some risk exist in real estate/property investment In spite of their potential advantages:

- Market Risk. It is similar with market beta in the CAPM and its factor betas in the APM. Market risk appears instantly as the price affected by change in market condition (inflation, others instrument volatility, etc)

- Liquidity Risk. The markets for many real estate investments are less liquid than markets for financial assets – transactions occur less frequently, transactions costs are higher and there are far fewer buyers and sellers. The less liquid an asset, it is argued, the more risky it is.

- Tax and Legal Exposure. Real estate investments are particularly exposed to changes in the tax law, because they derive a significant portion of their value from depreciation and tend to be highly levered.

- Information Risk. Real estate investments often require specific information about local conditions that is difficult (and costly) to obtain. The information is also likely to contain more noise. There are some who argue that this higher cost of acquiring information and the greater noise in this information should be built into the risk and discount rates used to value real estate.

Comprehensive reading about real estate valuation could be read in Damodaran (Investment Valuation)