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It's a big purchase, so why not invest some time in basic financial analysis

 (AP Photo/Richard Vogel)
(AP Photo/Richard Vogel) (Richard Vogel - AP)

When commercial real estate investors weigh a purchase, they think in terms of the "capitalization rate," or cap rate. Although home buyers should generally be thinking of a home purchase as a way to get a comfortable place to live, not as an investment, a little bit of the financial analysis that approximates what the big guys do can help you get a fair deal.

Here's how to calculate it. Make an educated guess as to what the home would rent for if it were on the open market. Granted, this is easier for condos, which have a more active rental market than single-family homes. Let's say that for a home, on sale for $400,000, the rent would be $2,000 a month. Subtract any condo or homeowner fees, monthly property taxes, insurance, and an allowance for repairs from that rental rate. Let's call that $500, meaning we're down to $1,500 a month. That's the monthly operating income an owner would expect to take in if the property were rented. Multiply that by 12 to make it an annual number, and divide by the purchase price. In this example, that leaves you with a 4.5 percent cap rate.

It doesn't matter that you are actually planning to live in the place rather than rent it out. When you buy a home, you are actually making two big financial decisions: First, that the place you are buying fits your lifestyle in terms of quality and affordability. And second, that it is more advantageous to buy that place than to rent it. In other words, you are paying rent to yourself instead of a landlord.

So what to do with the cap rate? Well, the first thing to notice is that it's very low. The rent you are paying yourself is not much of a return on the investment you have made. You can use the cap rate to compare homes you might buy to figure out which is the best deal when viewed purely as an investment. The higher the rate, the better.

Office buildings in the District and downtown business districts in other major cities routinely traded at a cap rate below 5 percent -- meaning at very high prices -- only during the peak of the real estate boom in 2005-07. Commercial cap rates have now risen to the 6-7 percent range.

But there are some big differences among jurisdictions that should shape your thinking. A low cap rate can be fine in a jurisdiction where rents are likely to rise quickly. In downtowns and close-in suburbs, rising demand for real estate is channeled into higher rents, because there isn't much empty land ready to be developed. In wide-open outer suburbs or rural areas, higher demand gets channeled into more housing production, so rents grow only at about the rate of inflation.

Lesson: Follow the lead of commercial real estate buyers, who have long relied on cap rates; for buildings downtown, rates are several percentage points lower than for comparable buildings in Reston or Columbia. Apply the same thinking to your own analysis of potential homes.

The limits of modeling

When I was looking to buy my place in the spring and summer of 2008, I constructed a ridiculously elaborate spreadsheet, using multiple valuation models and gaming out all kinds of scenarios of what might happen to inflation, taxes and interest rates. I even had the advantage of spending my days talking to some of the smartest economists on Earth about the outlook for all those variables.

What I didn't know -- nor did they -- is that a month after I closed on my two-bedroom condo, Lehman Brothers would file for bankruptcy, and the most severe financial crisis of modern times would set in, sending the global economy into a wrenching contraction.

Lesson: The future is inherently unpredictable, all the more so in these "unusually uncertain" times, as Bernanke called them recently. Ultimately, taking the plunge on a home purchase is about deciding that you want to live in a given place for years to come and that you have enough confidence in your own earnings prospects and the long-term growth of the economy to take the plunge on a purchase.

No spreadsheet can answer that question for you. Just ask Ben Bernanke.


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