What Is the Second Life Economy?
The Second Life Economy is an in-game marketplace where virtual goods and services are bought and sold in the immersive gaming world called Second Life. The Second Life Economy simulates a free market economy where players can buy and sell virtual goods with virtual money known as Linden Dollars, named after the game’s creator.
Users of Second Life, known as “residents”, can pay real money (e.g., in U.S. dollars) to acquire Linden dollars. Linden dollars (L$) can be used to buy, sell, rent, or trade virtual land, digital goods, and online services. Linden dollars can also be exchanged for U.S. dollars based on a floating rate. But Linden Labs stop short of allowing this currency to be a full-fledged fiat currency or even cryptocurrency.
Key Takeaways
- The Second Life Economy describes the ability to buy, sell, rent, and trade virtual goods and properties within the immersive multi-user game, Second Life.
- Second Life was developed by Linden Lab and was launched in June of 2003. Residents of the program interact with others through avatars.
- Linden Dollars ($L) is the currency used within Second Life.
Understanding Second Life Economy
Second Life is a virtual digital world created by Linden Labs and launched in 2003 that is still in existence. The game simulates the real world in that users (known as residents) can roam the world freely, meet and socialize with other residents, engage in communal activities, build residential and commercial properties, own lands, and conduct transactions in virtual goods and services using real or virtual currency.
Virtual goods traded in the economy range from art pieces and clothing to houses and cars. Some individuals and businesses thrive in the economy, while others struggle and may be forced into bankruptcy just like the real economy. It is estimated that Second Life has about 1 million active users per month. In 2015, the GDP of Second Life economy was estimated to be approximately $500 million dollars with its gross resident earnings averaging $60 million.
Goods in Second Life’s marketplace are bought and sold with a centralized virtual currency called Linden Dollars(L$.) To get Linden Dollars, residents convert their real money, e.g. euros, into Linden Money at the game’s official currency exchange site known as LindeX. Like a traditional exchange platform, market and limit buy and sell orders are conducted among the residents.
Linden Dollars are themselves worthless, and their value is potentially subject to currency manipulation or other adjustments to monetary policy by the developers at Linden Labs, who issue the currency. That said, the floating exchange rate between Linden$ and USD has remained fairly stable throughout Second Life, and has generally hovered around US $300-400/1L$ for the past few years.
The Linden dollar is a closed-loop virtual token for use only within the Second Life platform.
Linden Dollars as Virtual Currency
Because Linden dollars has a determinable value in the real market, the Financial Crimes Enforcement Network (FinCen), a bureau of the United States Department of the Treasury, recognized Linden Money as a convertible centralized virtual currency in 2013. This means that there are tax implications for any transaction involving Linden Dollars.
Virtual currency is not viewed as real money, but as property for tax purposes. Property tax laws, therefore, apply to Linden Dollar transactions. A taxpayer is required to include the fair market value of any Linden money obtained when calculating his gross income. If the taxpayer used the virtual currency strictly for investment gains, any capital gains or losses from the investments made are taxed appropriately.
Virtual goods in the economy can also be purchased using legal tender like US dollars. A resident who wants to build a home or business needs to purchase land from Linden Labs. For example, a 65,356m2 of land in the economy costs $1,675 in US dollars. A resident who has multiple lands may be charged a monthly fee by Linden Labs for use of the virtual land. This fee is used to pay for renting space on the game’s server and increases as more land is purchased by the resident.
The company’s terms of service state that players have no financial or legal claim to their L$, which are classified as a consumable entertainment product that can be revoked or deleted at any time without reason or warning.
Gambling Inside Second Life
Second Life Economy is a centralized marketplace. This means that Linden Labs, the economy’s administrator, retains the power to issue more of its currency, withdraw its currency from circulation, keep a ledger of transactions made by residents, and change the dynamics of the game. In 2007, following an FBI investigation into gambling practices in Second Life Economy, Linden Labs changed its game dynamics by banning all forms of gambling in its marketplace.
This move led to casino owners canceling their virtual land use agreements for the use and operation of casinos, which contributed a significant amount to the GDP of the economy and huge revenue in monthly fees to Linden Labs. Even virtual banks inside the Second Life Economy were affected as some of them had a lot of “ATMs” located in the major online casinos. This led to $L bank reserves being depleted, resulting in insolvency as the number of withdrawal requests mounted and led to virtual bank runs.
Real-World Wealth
Individual Second Life users have been reported to have accumulated vast fortunes by operating in the Second Life economy. One publicized example is that of Anshe Chung, a Second Life avatar of a real-life individual who, via the Anshe Chung avatar, had established a booming virtual real estate business within Second Life. Beginning by selling virtual furniture, fashion, and property designs, Chung reinvested her profits into buying up virtual property, and eventually become a virtual real estate magnate with $L worth more than US $1 million.
The example illustrates the ways in which the Second Life economy mirrors the activities of an economy trading in fiat currency. Today the individual behind Anshe Chung is a web personality and influence who employs dozens of virtual designers and programmers to support their Second Life activities.
Additionally, real-world companies are known to have taken advantage of the three-dimensional virtual market available in Second Life. Some companies operate in the virtual economy to promote charitable causes, others use it as a recruitment platform, and still, others use it to market their brand.
Kraft showcased its new products through its virtual supermarket in Second Life. IBM and Intel conducted virtual meetings. Calvin Klein’s new perfume release was promoted through the platform. Companies and schools use the market as a training tool for their employees and students in their virtual reality world.
Buying a house and renting an apartment represent only two of the possible living arrangements available, and these can both be cost-prohibitive. Co-op housing provides an alternative to the traditional methods of acquiring a primary residence.
A housing cooperative or “co-op” is a type of residential housing option that is actually a corporation whereby the owners do not own their units outright. Instead, each resident is a shareholder in the corporation based in part on the relative size of the unit that they live in. Here, we take a closer look at co-op living.
Key Takeaways
- A co-op is a way to own a primary residence, but where homeowners don’t own their units outright; instead, each resident is a shareholder in the co-op itself.
- Some co-op owners are allowed to sell their co-op shares in the open market, depending on the market rate for co-ops in that location.
- Co-ops can be less expensive than apartments since they operate on an at-cost basis, collecting money from residents to pay expenses.
- However, before buying shares of a company, be sure to check out the company’s financial situation and the fees involved.
How Housing Cooperatives Work
Owners of a co-op own shares of the cooperative instead of owning their unit outright, which would be the case in a condominium. With some co-ops, owners are allowed to sell their co-op shares in the open market, depending on the market rate for co-ops in that location, subject to approval by the co-op board.
Co-ops are often less expensive than rental apartments because they operate on an at-cost basis, collecting money from residents to pay outstanding bills. In areas where the cost of living is high, such as New York City, co-ops may be an attractive option from a financial perspective. Common fees paid to a co-op, however, may be quite a bit higher than those paid to a condo association.
In addition to the financial aspect of co-op ownership, there are also social aspects that must be taken into account. Smaller co-ops are run strictly by the residents, with everyone pitching in to take care of duties, such as maintenance, landscaping, and setting rules. Large co-ops may be run by a board of directors consisting of a subset of residents.
In either case, there are rules to be followed and a certain degree of social interaction that takes place. If you don’t like sharing decision-making authority, co-op living may not appeal to you.
Types of Co-ops
The structure of housing co-ops varies, depending on the specific jurisdiction of its location. In the U.S. and Canada, the most popular options include:
- Market Rate Co-ops: Allows co-op members to buy and sell shares at whatever rate the market will bear.
- Limited Equity Co-ops: Sets restrictions on the price at which shares may be bought and sold.
- Leasing Co-ops: The co-op corporation leases the building rather than owning it and accumulates no equity value. In this case, the co-op may have a cash reserve on hand if the building ever goes up for sale.
Costs to Purchase a Co-op
Since you are essentially buying shares of a company, be sure to check out the co-op’s financial situation and meet the other residents. They will be both your business associates and also your future neighbors. Before buying, you’ll want to consider the following:
- Location
- Amenities
- Costs
- Ability to lease your unit
- Pets policy
- Insurance requirements
To purchase shares in a co-op, each buyer takes out a “share loan” instead of a traditional mortgage. These loans operate much like mortgages, but in addition to the loan payments made to the lender, co-op residents are responsible for paying a pro-rata share of the common costs of running and maintaining the building.
Known as “maintenance,” these costs are generally paid to the partnership monthly and are billed on an at-cost basis. Maintenance may or may not include real estate taxes, and the annual fees paid to maintenance tend to go up each year with inflation.
The cost of the property’s mortgage may also be included in the monthly fee: Even if an individual tenant has paid off their share of the loan, it’s possible for the building itself to have a mortgage on it, held by the corporation, not by an individual partner. The share loan pays the cost of buying into the partnership. It has nothing to do with the underlying mortgage on the property itself. Buyers are entitled to all of the tax deductions enjoyed by homeowners, including the deductions for interest and real estate taxes.
Additional expenses include monthly utility bills for each buyer’s residence, which are paid on an individual basis, and insurance costs. While the building itself should be covered under a blanket insurance policy, the contents of each individual residence are not. A personal insurance policy, known as an HO-6, is required to protect personal possessions from water damage, fire, theft, and other calamities.
Special Considerations for Co-ops
Co-ops must abide by the laws that govern fair housing, but they can be more restrictive than other housing options when it comes to ownership requirements. Because there is no landlord, and there are no tenants, the rules for purchasing shares in the partnership are set by the partners.
For example, new buyers may be required to have a specific net worth or a certain debt-to-income ratio in addition to demonstrating the ability to meet the financial obligations of the co-op purchase.
A background check may also be required. Like other types of housing, some co-ops are designed to cater only to persons 65 years or older, or other specific groups. These more stringent ownership requirements lend an air of security and exclusivity to co-op ownership. In exchange for this exclusivity, co-ops are generally run in a more restrictive manner than condos. High-end units, for example, may forbid subleasing. All partners share in the costs of operating the building.
A default—or failure to pay—by one partner may require the other partners to cover that partner’s costs, although the strict ownership requirements generally keep defaults to a minimum.
Condominiums vs. Cooperatives
Condominiums are multi-unit dwellings with privately owned residences that maintain shared common areas and infrastructure such as elevators, basements, or rooftops. Condominiums are classified as real property, meaning that buyers own the deeds to their dwellings. If you are considering buying a condo, it is beneficial to research your mortgage options using a mortgage calculator like the one below.
Co-ops are not considered real property. When you buy into a co-op, you become a shareholder in a corporation that owns the property. As a shareholder, you are entitled to exclusive use of a housing unit in the property.
The Bottom Line
Always read the co-op’s articles of incorporation, bylaws, subscription agreement, rules, and any other available documentation. Make sure you truly understand how the cooperative works, including how it is managed, what you will be required to pay for, and how much that payment will be. Ask about the terms of any underlying mortgage, the policy toward pets, and your ability to make changes to your residence. There’s no harm in asking questions; a little extra effort up front can go a long way toward ensuring a harmonious long-term living arrangement.
Mortgage lending discrimination is illegal. If you think you’ve been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau or with the U.S. Department of Housing and Urban Development (HUD).
When it comes to individual retirement accounts (IRAs), financial assets—stocks, bonds, mutual funds, or exchange-traded funds (ETFs)—are the usual investment suspects. Still, it’s possible to hold real estate in your IRA under certain conditions. For example, you can buy single-family or multiplex homes; apartment buildings; commercial properties such as retail stores, hotels, office complexes, raw land and lots; and even boat slips.
However, it’s not as easy as purchasing a few hundred shares of stock. If you want to plunge into property purchases through your self-directed IRA, you need to know the rules—and there are many of them.
Key Takeaways
- You can hold real estate in your IRA, but you’ll need a self-directed IRA.
- Any real estate property you buy must be strictly for investment purposes; you and your family can’t use it.
- Purchasing real estate within an IRA usually requires paying in cash, and the IRA must pay all ownership expenses.
- Holding real estate in your IRA can be tricky, with tax issues and red tape. But on the other hand, property can provide you with a good (or great) rate of return and diversify your portfolio.
The Right IRA for Buying Investment Property
First of all, your IRA has to be self-directed. The term “self-directed” means that alternative investments are accepted or offered by the IRA custodian, the financial institution, or the company responsible for record-keeping and Internal Revenue Service (IRS) reporting requirements. A self-directed IRA is independent of any brokerage, bank, or investment company that would make decisions for you (most brokerage accounts don’t allow real estate holdings, anyway).
To buy and own property via your IRA, you will still need a custodian, an entity specializing in self-directed accounts that will manage the transaction, associated paperwork, and financial reporting. Everything goes through the custodian to keep you from violating the strict rules regarding these real estate transactions.
As you would expect, the custodian will charge a fee for the service. However, it won’t advise you on how to best structure your holdings. Instead, this custodian’s job is to handle the back-office work.
Before we look at the rest of the rules, understand this basic fact: You and your IRA are two separate entities. Your IRA owns the property—you don’t. Therefore, the title to the property will read “XYZ Trust Company Custodian [for benefit of] (FBO) [Your Name] IRA.”
If you buy real estate with your IRA improperly, you can disqualify the IRA. If that happens, all the funds in it immediately become taxable.
What Is and Isn’t Yours
Your real estate property must be purely an investment. You can’t use it as a vacation home, a place for your kids to live, a second home, or an office for your business. These rules apply to you and to people the IRS deems “disqualified.” So who is considered a disqualified person?
- Your spouse
- Your parents, grandparents, and great-grandparents
- Your children and their spouses, grandchildren, and great-grandchildren
- Service providers of your IRA
- Any entity that owns more than 50% of the property
You also can’t purchase the property from one of these disqualified people—this is called a self-dealing transaction—nor can the IRA purchase property that you already own. You can learn more about prohibited transactions in section 4.72.11.2.1 of the Internal Revenue Manual.
Making the Purchase in an IRA
Your IRA balance will have to be pretty high because getting a mortgage to purchase property inside an IRA isn’t easy. You’ll likely have to pay in cash, which takes a big bite out of the account and affects your rate of return down the road.
Real estate investors often put down a small amount and take advantage of still relatively low-interest rates to leverage the purchase, figuring they can make more money on the property than they’ll pay in interest. If you can’t finance your real estate purchase, you lose that potential for a significant return on investment (ROI).
Some banks will consider loans for this sort of transaction, but it presents another problem: Any revenue from the property may then be considered unrelated business taxable income (UBTI). You can learn more about UBTI from Section 511 of the IRS Internal Revenue Code (IRC).
Owning the Property in an IRA
As your IRA doesn’t pay taxes, you can’t take advantage of the deductions that come with owning real estate. Because you’ve paid cash, there are no mortgage interest payments to deduct. Nor do you get the benefits of property tax deductions or depreciation. If your property generates rental income, every bit of it goes right back into your IRA. As you don’t own the property, you can’t pocket any of the income. (Of course, you will get the money eventually when you make withdrawals from the account at retirement.)
On the bright side, none of the maintenance or other associated costs of owning real estate comes out of your pocket. The IRA pays for everything. However, this is not without drawbacks. Every dollar that comes out of your IRA is a dollar that no longer gets a couple of decades to appreciate in value tax-free.
One colossal risk is maintenance expenses that can drain your IRA’s cash and lead to expensive penalties if you “overcontribute” to the account to cover them.
And what happens if a property incurs a series of major expenses that push your IRA balance so low that the account doesn’t have enough money to pay for it? Remember, you can’t pay for anything relating to this property out of your pocket, and IRA contributions are limited: The annual contribution limit for 2023 is $6,500 and $7,500 if you’re 50 or older ($6,000 and $7,000 in 2022).
If that doesn’t cover the repair, and you have to deposit more, you’re on the hook for penalties associated with contributing too much. This is a significant risk, as property can often require pricey upkeep, and the income you get from rentals may not cover what you need to spend in a high-maintenance year.
Selling the Property in an IRA
Work out a sales price to sell your property just as you would with any other real estate holding. Once both parties agree on a price and terms, request that your custodian sell the property on behalf of your IRA. All money will go back into your IRA, either tax-deferred or tax-free, depending on the makeup of your IRA.
One final consideration: liquidity. Just how easy is it for you to get out of the investment? With stocks, it’s relatively easy. Sometimes you can have your money back in seconds. In contrast, real estate is a notoriously illiquid investment. It may take a long time to divest, and you could lose money along the way. As nearly ten million people learned in the Great Recession of 2008, you could find yourself with an asset worth less than the amount of money you owe on it.
Pros and Cons of Property in an IRA
We’ve mentioned so many hassles and drawbacks that you might be wondering at this point if there is any point in putting property in an IRA. Historically, real estate has been an excellent long-term investment as property values rise over time, and long-term appreciation goes hand-in-hand with the long-term investment horizon of a retirement account. In the short term, any income the property generates is tax-sheltered within the IRA. Finally, as a hard asset, real estate helps diversify a portfolio otherwise invested in equities and other securities—not the worst idea in the world.
-
Real estate helps diversify a portfolio, often moving counter to financial markets.
-
Real estate has historically appreciated over time, ideal for an IRA’s long-term investment horizon.
-
Real estate can provide a steady income stream from rents, and any rental income you collect grows tax-free within the IRA.
-
You can buy, sell, flip, and accumulate properties.
-
You need to set up a self-directed IRA with a custodian.
-
You can’t claim deductions for property taxes, mortgage interest, depreciation, and other property-related expenses.
-
All expenses, repairs, and maintenance costs must be paid with IRA funds, and you must pay others to do them and manage the property.
-
You and your relatives can’t live in or run a business out of the property.
Can You Finance Real Estate With Self-Directed IRAs?
It’s important to remember that funds (cash) from the IRA are generally used to purchase the property; additionally, the IRA will own the property and it can only be used for investment purposes.
Who Owns Property in a Self-Directed IRA?
Funds from the IRA are used to purchase the property, and the account legally owns the property.
Can I Build a House With A Self-Directed IRA?
An IRA can only be used to purchase investment property, so you cannot build a house using the account even if you intend to use it as an investment property.
The Bottom Line
Using a Roth or traditional IRA to buy an investment property is not for the faint of heart, nor is it for anyone unfamiliar with the differing types of individual retirement accounts. Real estate investing of any type is quite risky or, at best, high maintenance; for an IRA, real estate is a particularly high-risk choice. Not only may property values drop rather than rise, but a year of significant maintenance costs could also subject you to penalties if your income and IRA contribution limit doesn’t cover repairs you can’t afford to ignore.
Unless you have the time and expertise to manage real property, you are probably best off with more mainstream strategies for your IRA. Or consider securitized real estate options, like real estate investment trusts (REITs) or mutual funds and ETFs that invest in property. These are an indirect form of property ownership, but they’re a more straightforward, liquid proposition—and they can also be held in regular IRAs.
Those who invest in real estate, as with any asset, constantly face decisions whether to buy, sell, or hold. And those decisions depend on evaluating the property in question. Valuing real estate using discounted cash flow or capitalization methods is similar to valuing stocks or bonds. The only difference is that cash flows are derived from leasing space as opposed to selling products and services.
Real estate investment companies have developed sophisticated valuation models to aid them in their decisions. However, by using spreadsheet tools an individual can produce an adequate valuation on most income-producing real estate – including residential real estate purchased to serve as a residential rental property.
Read on to find out how any investor can create a valuation satisfactory enough to weed through prospective investment opportunities.
Individual Valuations
Some individuals feel that producing a valuation is unnecessary if a certified appraisal has been completed. However, an investor’s valuation may differ from an appraiser’s for several reasons.
The investor may have different opinions about the property’s ability to attract tenants or the lease rates that tenants are willing to pay. As a prospective purchaser or seller, the investor may feel that the property has more or less risk than the appraiser.
Appraisers conduct separate assessments of value. They include the cost to replace the property, a comparison of recent and comparable transactions and an income approach. Some of these methods commonly lag the market, underestimating value during uptrends, and overvaluing assets in a downtrend.
Finding opportunities in the real estate market involves finding properties that have been incorrectly valued by the market. This often means managing a property to a level that surpasses market expectations. A valuation should provide one’s estimate of the true income-producing potential of a property.
Real Estate Valuation
The income approach to evaluating real estate is similar to the process for valuing stocks, bonds, or any other income-generating investment. Most analysts use the discounted cash flow (DCF) method to determine an asset’s net present value (NPV).
NPV is the property value in today’s dollars that will achieve the investor’s risk-adjusted return. The NPV is determined by discounting the periodic cash flow available to owners by the investor’s required rate of return (RROR). Since the RROR is an investor’s required rate of return for the risks involved, the value derived is a risk-adjusted value for that individual investor. By comparing this value to market prices, an investor is able to make a buy, hold, or sell decision.
Stock values are derived by discounting dividends, bond values by discounting interest coupon payments. Properties are valued by discounting net cash flow or the cash available to owners after all expenses have been deducted from leasing income. Valuing a property involves estimating all the rental revenues and then deducting all expenses required to execute and maintain those leases.
Breaking Down Leases
All income estimates come directly from leases. Leases are contractual agreements between tenants and a landlord. All rent and contractual increases in rent (escalations) will be spelled out in the leases, as well as options for space and rent concessions. Owners also recoup part or all of the property expenses from tenants. The manner in which this income is collected is also stated in the lease contract. There are three main types of leases:
In full-service leases (also called gross leases), tenants do not pay anything in addition to rent. In net leases, tenants usually pay their portion of the increase in expenses for the period after they move into the property. In triple-net leases, the tenant pays a pro-rata share of all property expenses.
The following are the types of expenses that have to be considered when preparing an income valuation:
- Leasing costs
- Management cost
- Capital costs
Leasing costs refer to the expenses necessary to attract tenants and to execute leases. Management costs refer to property-level expenses, such as utilities, cleaning, taxes, etc. as well as any costs to manage the property. Income less operating expenses equals net operating income (NOI). NOI is the cash flow derived from the normal operations of the property. Cash flow is then derived by subtracting capital costs from NOI. Capital costs are any periodic capital outlays to maintain the property. These include any capital for leasing commissions, tenant improvements, or capital reserves for future property upgrades.
Valuation Example
Once periodic cash flows are determined, they can be discounted back to determine property value. Figure 1 shows a simple valuation design that can be adjusted to value most properties.
Assumption | Value | Assumption | Value |
Growth in Income Yr1-10 (g) | 4% | Growth in Income Yr11+ (g) | 3% |
RROR (K) | 13% | Expenses % of Income | 40% |
Capital Expenses | $10,000 | Reversion Cap Rate (K-g) | 10% |
Figure 1
The valuation assumes a property that creates an annual rental income of $100,000 in year one, which grows by 4% annually and 3% after year 10. Expenses are estimated at 40% of income. Capital reserves are modeled at $10,000 per year. The discount rate, or RROR, is set at 13%. The capitalization rate for determining the reversion value of the property in year 10 is estimated at 10%. In financial terminology, this capitalization rate equals K-g, where K is the investor’s RROR (required rate of return) and is the expected growth in income. K-g is also known as the investor’s required income return, or the amount of the total return that is provided by income.
The value of the property in year 10 is derived by taking the estimated NOI for year 11 and dividing it by the capitalization rate. Assuming the investor’s required rate of return stays at 13% then the capitalization would equal 10%, or K-g (13% – 3%). In Figure 2, NOI in year 11 is $88,812. After periodic cash flows are calculated, they are then discounted back by the discount rate (13%) to derive the NPV of $58,333.
Item | Yr 1 | Yr 2 | Yr 3 | Yr 4 | Yr 5 | Yr 6 | Yr 7 | Yr8 | Yr 9 | Yr 10 | Yr 11 |
Income | 100 | 104 | 108.16 | 112.49 | 116.99 | 121.67 | 126.54 | 131.60 | 136.86 | 142.33 | 148.02 |
Expenses | -40 | -41.60 | -43.26 | -45 | -46.80 | -48.67 | -50.62 | -52.64 | -54.74 | -56.93 | -59.21 |
Net Operating Income (NOI) | 60 | 62.40 | 64.896 | 67.494 | 70.194 | 73.002 | 75.924 | 78.96 | 82.116 | 85.398 | 88.812 |
Capital | -10 | -10 | -10 | -10 | -10 | -10 | -10 | -10 | -10 | -10 | – |
Cash Flow (CF) | 50 | 52.40 | 54.90 | 57.49 | 60.19 | 63 | 65.92 | 68.96 | 72.12 | 75.40 | – |
Reversion | – | – | – | – | – | – | – | – | – | 888.12 | – |
Total Cash Flow | 50 | 52.40 | 54.90 | 57.49 | 60.19 | 63 | 65.92 | 68.96 | 72.12 | 963.52 | – |
Dividend Yield | 9% | 9% | 9% | 10% | 10% | 11% | 11% | 12% | 12% | 13% | – |
Figure 2 (in thousands of dollars)
Figure 2 provides a basic format that can be used to value any income-producing or rental property. Investors purchasing residential real estate as rental property should prepare valuations to determine whether rental rates being charged are adequate enough to support the purchase price of the property. Although appraisers will often use a 10-year cash flow by default, investors should produce cash flows that mirror the assumptions on which the property is assumed to be purchased. This format, although simplified, can be adjusted to value any property, regardless of complexity. Even hotels can be valued this way. Just think of nightly room rentals as one-day leases.
Buy, Sell or Hold
When purchasing a property, if an investor’s assessed value is greater than the seller’s offer or appraised value, then the property can be purchased with a high probability of receiving the RROR. Conversely, when selling a property, if the assessed value is less than a buyer’s offer, the property should be sold. In addition, if the assessed value is in line with the market and the RROR offers an adequate return for the risk involved, the owner may decide to hold the investment until there is a disequilibrium between the valuation and market value.
Value can be defined as the greatest amount that someone would be willing to pay for a property. When purchasing an asset, financing should not affect the ultimate value of the property because each buyer has different financing options available.
However, this is not the case for investors who already own properties that have been financed. Financing must be considered when deciding on an appropriate time to sell because financing structures, such as prepayment penalties, can rob the investor of his or her sale’s proceeds. This is important in cases where investors have received favorable financing terms that are no longer available in the market. The existing investment with debt may provide better risk-adjusted returns than can be achieved when reinvesting the prospective sales proceeds. Adjust risk RROR to include the additional financial risk of mortgage debt.
The Bottom Line
Whether buying or selling, it is possible to produce a valuation model accurate enough to assist in the decision-making process. The math involved in creating the model is relatively straightforward and within the grasp of most investors. After gaining some rudimentary knowledge about local market standards, lease structures and how income and expenses work in different property types, one should be able to forecast future cash flows.
There are several questions investors ask must themselves when it comes to investing their hard-earned money. How much will the investment return? What does it cost? But more importantly, investors should be concerned with its value. This is especially true when you consider purchasing an investment property.
Income from investment-related property is at a historical high. Rents offer an increasing source of revenue, and it’s a steady way to make money. But before getting into the real estate rental game, how does one go about making evaluations?
Read on to find out some of the most common ways to value high-level rental property.
Key Takeaways
- Determining the cost of and the return on an investment property are just as important as figuring out its value.
- Investors can use the sales comparison approach, the capital asset pricing model, the income approach, and the cost approach to determine property values.
- There isn’t a one-size-fits-all solution, so a combination of these factors may need to be applied.
1. The Sales Comparison Approach
The sales comparison approach (SCA) is one of the most recognizable forms of valuing residential real estate. It is the method most widely used by appraisers and real estate agents when they evaluate properties.
This approach is simply a comparison of similar homes that have sold or rented locally over a given time period. Most investors will want to see an SCA over a significant time frame to glean any potentially emerging trends.
The SCA relies on attributes or features to assign a relative price value. These values may be based on certain characteristics such as the number of bedrooms and bathrooms, garages and/or driveways, pools, decks, fireplaces—anything that makes a property unique and noteworthy.
Price per square foot is a common and easy-to-understand metric all investors can use to determine where their property should be valued. In other words, if a 2,000-square-foot townhouse is renting for $1/square foot, investors can reasonably expect income in that ballpark, provided comparable townhouses in the area are going for that, too.
Example of Sales Comparison Approach
Keep in mind that SCA is somewhat generic—that is, every home has a uniqueness that isn’t always quantifiable. Buyers and sellers have unique tastes and differences. The SCA is meant to be a baseline or reasonable opinion, and not a perfect predictor or valuation tool for real estate. It’s also a method that should be used to compare to relatively similar homes.
So it doesn’t work if you’re going to value the property you’re interested in, which is 2,000 square feet with a garage, swimming pool, six bedrooms, and five full bathrooms with another property that has half the number of bedrooms, no pool and is only 1,200 square feet.
It is also important for investors to use a certified appraiser or real estate agent when requesting a comparative market analysis. This mitigates the risk of fraudulent appraisals, which became widespread during the 2007 real estate crisis.
2. The Capital Asset Pricing Model
The capital asset pricing model (CAPM) is a more comprehensive valuation tool. The CAPM introduces the concepts of risk and opportunity cost as it applies to real estate investing.
This model looks at the potential return on investment (ROI) derived from rental income and compares it to other investments that have no risk, such as United States Treasury bonds or alternative forms of investing in real estate, such as real estate investment trusts (REITs).
In a nutshell, if the expected return on a risk-free or guaranteed investment exceeds potential ROI from rental income, it simply doesn’t make financial sense to take the risk of rental property. With respect to risk, the CAPM considers the inherent risks to rent real property.
Risk Factors
For example, all rental properties are not the same. Location and property age are key considerations. Renting older property means landlords will likely incur higher maintenance expenses.
Property for rent in a high-crime area will likely require more safety precautions than a rental in a gated community.
This model suggests factoring in these risks before considering your investment or when establishing a rental pricing structure. CAPM helps you determine what return you deserve for putting your money at risk.
3. The Income Approach
The income approach focuses on what the potential income for rental property yields relative to the initial investment. The income approach is used frequently for commercial real estate investing.
The income approach is used frequently with commercial real estate investing because it examines potential rental income on a property relative to the initial outlay of cash to purchase the real estate.
The income approach relies on determining the annual capitalization rate for an investment. This rate is the projected annual income from the gross rent multiplier divided by the current value of the property. So if an office building costs $120,000 to purchase and the expected monthly income from rentals is $1,200, the expected annual capitalization rate is: 14,400 ($1,200 x 12 months) ÷ $120,000 = 0.12 or 12%
This is a very simplified model with few assumptions. More than likely, there are interest expenses on a mortgage. Also, future rental incomes may be more or less valuable five years from now than they are today.
Many investors are familiar with the net present value of money. Applied to real estate, this concept is also known as a discounted cash flow. Dollars received in the future are subject to inflationary as well as deflationary risk, and are presented in discounted terms to account for this.
4. Gross Rent Multiplier Approach
The gross rent multiplier (GRM) approach values a rental property based on the amount of rent an investor can collect each year. It is a quick and easy way to measure whether a property is worth the investment. This, of course, is before considering any taxes or other expenses such as insurance and utilities associated with the property, so it should be taken with a grain of salt.
While it may be similar to the income approach, the gross rent multiplier approach doesn’t use net operating income as its cap rate, but gross rent instead.
The gross rent multiplier’s cap rate is greater than one, while the cap rate for the income approach is a percentage value. In order to get an apples-to-apples comparison, you should look at the GRMs and rental income of other, similar properties to the one in which you’re interested.
Example of Gross Rent Multiplier Approach
Let’s say a commercial property sold in the neighborhood you’re looking at for $500,000, with an annual income of $90,000. To calculate its GRM, we divide the sale price (or property value) by the annual rental income: $500,000 ÷ $90,000 = 5.56.
You can compare this figure to the one you’re looking at, as long as you know its annual rental income. You can find out its market value by multiplying the GRM by its annual income. If it’s higher than the one that sold recently—i.e. for $500,000—it may not be worth it, so consider moving on.
5.The Cost Approach
The cost approach to valuing real estate states that property is only worth what it can reasonably be used for. It is estimated by combining the land value and the depreciated value of any improvements.
Appraisers from this school often espouse the highest and best use to summarize the cost approach to real property. It is frequently used as a basis to value vacant land.
For example, if you are an apartment developer looking to purchase three acres of land in a barren area to convert into condominiums, the value of that land will be based upon the best use of that land. If the land is surrounded by oil fields and the nearest person lives 20 miles away, the best use and therefore the highest value of that property is not converting to apartments, but possibly expanding drilling rights to find more oil.
Another best use argument has to do with property zoning. If the prospective property is not zoned for residential purposes, its value is reduced, as the developer will incur significant costs to get rezoned. This approach is considered most reliable when used on newer structures and less reliable for older properties. It is often the only reliable approach when looking at special use properties.
The Bottom Line
There is no one way to determine the value of a rental property. Most serious investors look at components from all of these valuation methods before making investment decisions about rental properties. Learning these introductory valuation concepts should be a step in the right direction to getting into the real estate investment game.
Then, once you’ve found a property that can yield you a favorable amount of income, find a favorable interest rate for your new property using a mortgage calculator. Using this tool will also give you more concrete figures to work with when evaluating a prospective rental property.