Investment Rating for Real Estate
Encyclopedia
An investment rating of a real estate
property measures the property’s risk-adjusted returns, relative to a completely risk-free asset. Mathematically, a property’s investment rating is the return a risk-free asset would have to yield to be termed as good an investment as the property whose rating is being calculated. The underlying drivers for property ratings are the dividends (net operating income
) and capital gain
s over a certain holding period, and their associated risks or variances. Similar to other financial ratings developed for mutual fund
s and stocks, it can be assumed that investors have constant relative risk aversion
over the wealth derived from other sources and from their investments. For simplicity, it can also be assumed that the investment return is not correlated with other sources of wealth but represents a 100% of the investor's wealth. A property’s investment rating is then a transformation of the risk-adjusted averaged return to a single number that conveys the property’s long-term potential to yield profits.
wrote in The Wealth of Nations
over 200 years ago that "a dwelling-house, as such, contributes nothing to the revenue of its inhabitants". The Economist has reported that most Americans were treating their homes as an investment till 2008. The traditional belief that home ownership
is a necessary milestone to acquiring wealth still holds. Not everyone considers their home as a long-term investment asset http://seekingalpha.com/article/63072-is-your-home-an-investment; some believe they can get better returns in other assets http://online.wsj.com/article/SB124336746233955539.html. By owning a home to live in, the owner not only saves on rent but also benefits from any long-term price appreciation. And investors, those that buy a home to rent out, are in it primarily for financial gains, be it monthly cash flow
income, long-term gain, or a combination of both. But, investors and live-in home owners alike should care for the net returns a home can yield, since it is, for most, the single largest investment they will ever make.
is necessary, but not sufficient, especially in uncertain times.
There are hundreds of macro and micro factors that could potentially impact a property's financial returns, including price appreciation, ability to put it on rent, and vacancy, fair market value
, mortgage, maintenance expenses, property tax
, property management
fee (if any), and home insurance
. Add on top attributes that span markets, housing, government, community, demographic and lifestyle parameters. A sound rating analysis should cover all aspects of location – national, state, metro, county, city, tracts down to neighborhoods and the property itself. One should be able to measure and factor in the inherent risk/volatility in all of these attributes to arrive at a measure that can be correlated to a financially sound decision on the next home purchase
No one has a crystal ball
, of course. So, any rating of this nature should be interpreted as a 'relative' measure, and used as a way to rank/compare homes for their relative investment potential. In other words, a highly rated home is likely to outperform a low-rated home. So, homes in the top quartile are most likely to outperform all other homes.
Real estate
In general use, esp. North American, 'real estate' is taken to mean "Property consisting of land and the buildings on it, along with its natural resources such as crops, minerals, or water; immovable property of this nature; an interest vested in this; an item of real property; buildings or...
property measures the property’s risk-adjusted returns, relative to a completely risk-free asset. Mathematically, a property’s investment rating is the return a risk-free asset would have to yield to be termed as good an investment as the property whose rating is being calculated. The underlying drivers for property ratings are the dividends (net operating income
Earnings before interest and taxes
In accounting and finance, earnings before interest and taxes is a measure of a firm's profit that excludes interest and income tax expenses. Operating income is the difference between operating revenues and operating expenses...
) and capital gain
Capital gain
A capital gain is a profit that results from investments into a capital asset, such as stocks, bonds or real estate, which exceeds the purchase price. It is the difference between a higher selling price and a lower purchase price, resulting in a financial gain for the investor...
s over a certain holding period, and their associated risks or variances. Similar to other financial ratings developed for mutual fund
Mutual fund
A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors to buy stocks, bonds, short-term money market instruments, and/or other securities.- Overview :...
s and stocks, it can be assumed that investors have constant relative risk aversion
Risk aversion
Risk aversion is a concept in psychology, economics, and finance, based on the behavior of humans while exposed to uncertainty....
over the wealth derived from other sources and from their investments. For simplicity, it can also be assumed that the investment return is not correlated with other sources of wealth but represents a 100% of the investor's wealth. A property’s investment rating is then a transformation of the risk-adjusted averaged return to a single number that conveys the property’s long-term potential to yield profits.
Home as an investment asset
The jury is still out there. Adam SmithAdam Smith
Adam Smith was a Scottish social philosopher and a pioneer of political economy. One of the key figures of the Scottish Enlightenment, Smith is the author of The Theory of Moral Sentiments and An Inquiry into the Nature and Causes of the Wealth of Nations...
wrote in The Wealth of Nations
The Wealth of Nations
An Inquiry into the Nature and Causes of the Wealth of Nations, generally referred to by its shortened title The Wealth of Nations, is the magnum opus of the Scottish economist and moral philosopher Adam Smith...
over 200 years ago that "a dwelling-house, as such, contributes nothing to the revenue of its inhabitants". The Economist has reported that most Americans were treating their homes as an investment till 2008. The traditional belief that home ownership
Owner-occupier
An owner-occupier is a person who lives in and owns the same home. It is a type of housing tenure. The home of the owner-occupier may be, for example, a house, apartment, condominium, or a housing cooperative...
is a necessary milestone to acquiring wealth still holds. Not everyone considers their home as a long-term investment asset http://seekingalpha.com/article/63072-is-your-home-an-investment; some believe they can get better returns in other assets http://online.wsj.com/article/SB124336746233955539.html. By owning a home to live in, the owner not only saves on rent but also benefits from any long-term price appreciation. And investors, those that buy a home to rent out, are in it primarily for financial gains, be it monthly cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
income, long-term gain, or a combination of both. But, investors and live-in home owners alike should care for the net returns a home can yield, since it is, for most, the single largest investment they will ever make.
Rating evaluation
Objective evaluation of a property's intrinsic long-term "worth", requires a rating process as mature as the process for stocks and funds. Knowing a property's current market priceMarket price
In economics, market price is the economic price for which a good or service is offered in the marketplace. It is of interest mainly in the study of microeconomics...
is necessary, but not sufficient, especially in uncertain times.
There are hundreds of macro and micro factors that could potentially impact a property's financial returns, including price appreciation, ability to put it on rent, and vacancy, fair market value
Fair market value
Fair market value is an estimate of the market value of a property, based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the market. An estimate of fair market value may be founded either on precedent or...
, mortgage, maintenance expenses, property tax
Property tax
A property tax is an ad valorem levy on the value of property that the owner is required to pay. The tax is levied by the governing authority of the jurisdiction in which the property is located; it may be paid to a national government, a federated state or a municipality...
, property management
Property management
Property management is the operation, control of ususally on behalf of an owner, and oversight of commercial, industrial or residential real estate as used in its most broad terms. Management indicates a need to be cared for, monitored and accountability given for its usable life and condition...
fee (if any), and home insurance
Home insurance
Home insurance, also commonly called hazard insurance or homeowner's insurance , is the type of property insurance that covers private homes...
. Add on top attributes that span markets, housing, government, community, demographic and lifestyle parameters. A sound rating analysis should cover all aspects of location – national, state, metro, county, city, tracts down to neighborhoods and the property itself. One should be able to measure and factor in the inherent risk/volatility in all of these attributes to arrive at a measure that can be correlated to a financially sound decision on the next home purchase
No one has a crystal ball
Crystal ball
A crystal ball is a crystal or glass ball believed by some people to aid in the performance of clairvoyance. It is sometimes known as a shew stone...
, of course. So, any rating of this nature should be interpreted as a 'relative' measure, and used as a way to rank/compare homes for their relative investment potential. In other words, a highly rated home is likely to outperform a low-rated home. So, homes in the top quartile are most likely to outperform all other homes.
Advantages of real estate rating
- Investors
- Locate best places to invest
- Identify properties with the most value
- Provide objective criteria to establishes the right price range
- Compute rent income to expect
- Project expected long-term cash flow and appreciation
- Sellers and listing agents
- Calculate best price for rapid sale
- Help in expanding properties market to national buyers pool
- Differentiate values of properties
- Build confidence in the value of a transaction
- Lenders
- Establish collateral value (both current & future) of a property
- Assess potential loss in a foreclosure
- Simplify decision to either foreclose or modify a loan
Rating systems
- InvestMarq.com CashflowScore
- FinestExpert.com FE-Score
- Case–Shiller home price indexCase–Shiller indexThe Standard & Poor's Case–Shiller Home Price Indices are constant-quality house price indices for the United States. There are multiple Case–Shiller home price indices: A national home price index, a 20-city composite index, a 10-city composite index, and twenty individual metro area...
- Morningstar for funds and stocks:
- Fitch rating for residential mortgage backed securities
- S&P Ratings
- Country investment ratings: Shows the countries where buy-to-let property earns the highest returns
- ConsumerReports investment ratings