Basic Methods of Analysis for Real Estate Investment

Author: Akito Hashimoto

This article has been translated from the original by the LIFULL International Investments Group.

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Last year the "Kabocha No Basha" scandal brought Suruga Bank's inadequate screening process for financing to light.
One particular example of inadequate screening measures was the oversight of double contracts.

Normally, banks decide the amount of financing for a property, and the investor has to make a down payment equal to the difference between the mortgage amount and sale price. Banks cannot offer financing if no down payment can be made.

For example, let's say a bank decides to offer a mortgage at 90% for a 100 million yen property with miscellaneous costs of 5 million yen. In this case, the maximum mortgage amount would be 100 million yen x 90% = 90 million yen. Therefore, the investor would need to make a down payment of 10 million yen + 5 million yen miscellaneous fees (total of 15 million yen.)

However, if the investor cannot come up with 15 million yen, the sale price listed in the contract could be changed to 117 million yen. This would increase the mortgage amount to 117 million yen x 90% = 105.3 million yen which would mean that the investor would receive enough financing to cover all costs without a down payment.

Suruga Bank was turning a blind eye to companies obtaining financing through these kinds of contracts. Since payment amounts increased with the total mortgage, loans seem to have been approved through a chain of fraud, such as setting higher rents.

So, let's get to the point.

According to the news, the investors trusted these companies and banks completely. On the one had, it resulted in a bad ending for investors who trusted that the companies selling the properties weren't doing anything illegal. However, one also has to admit that these investors did not possess the real estate investment literacy they needed to make informed decisions.

When beginning to invest in real estate, investors need to obtain at least basic knowledge to protect themselves from dangerous investment pitches. This is because investing is always at your own risk.

Even if you are talking about stocks, there are a few basic decision-making techniques. For example, it would be difficult to find investors who don't understand terms such as technical analysis, index investment, active investment, PER, PBR, and ROE.
Investing in real estate is just like stocks: there are ways to analyze investments.

In this article, I will introduce a few of these methods of analyzing potential investments as an investor.

Discounted Cash Flow (DCF) Analysis

A DCF analysis is a method of obtaining the revenue price of real estate by adding the sum of the present value of net revenue generated during the holding period of the investment property and the present value of the selling price at the end of the holding period.

Even if the property is generating 10 million yen in revenue, 10 million yen this year will not be the same as 10 million yen in 5 years due to inflation. For this reason, you will have to account for inflation in the revenue and change the present price. To do this, you can use a DCF analysis.

Aside from real estate, DCF analyses are also useful in other long-term investments.

Net Present Value (NPV) Analysis

In an NPV analysis, we compare the revenue price obtained in the DCF analysis and the sale price. If the sale price is lower, the property will be a good investment, but not if the sale price is higher.

Examples of DCF and NPV Analyses

In this example, we will assume a 2% increase in the price of goods, we have a property that generates a rental income of 10 million yen annually, and we plan to sell it for 120 million yen in 5 years. Will this be a good investment?

Let's calculate the DCF for this example. The calculation is as follows:

(1) Revenue in 1st Year 10 mil. yen ×1/1.02≒9.804 mil. yen
(2) Revenue in 2nd Year 10 mil. yen ×1/1.02 ²≒9.612 mil. yen
(3) Revenue in 3rd Year 10 mil. yen ×1/1.02 ³≒9.423 mil. yen
(4) Revenue in 4th Year 10 mil. yen ×1/1.02 ⁴≒9.238 mil. yen
(5) Revenue in 5th Year 10 mil. yen ×1/1.02 ⁵≒9.057 mil. yen
(6) Sale Price 100 mil. yen ×1/1.02 ⁵≒90.57 mil. yen
(1)+(2)+(3)+(4)+(5)+(6)≒137.7 mil. yen (Revenue Price)

Through an NPV analysis, you can judge whether or not there will be an investment value.

In this example, we can see that this will be a good investment, since the selling price of 120 million yen is lower than the revenue price.

DSCR (Debt Service Coverage Ratio)

This is an index to determine how much of a gap there is between the annual cash flow and the repayment amount.

This can calculated by dividing the annual net revenue before payment of the principal and interest by the annual interest payment amount.
The higher this amount, the more of a gap for payment there is.

A DSCR of 1.6 or more is generally considered safe for real estate investment.

Example

Let's take a property that has an annual revenue of 20 million yen and an annual total principal and interest payment of 15 million yen Would this be a sound investment?

Calculation

20 mil. yen / 15 mil. yen = 1.33x

This property has a DSCR of under 1.6, so we couldn't really say that it was a safe investment.

There are a number of other investment analysis methods such as Internal Rate of Return (IRR), judgment based on the repayment ratio, so I recommend looking over them.

Companies will use these kinds of analyses during sales talks with you. However, as an investor, understanding the basics of investment analyses and the ability to judge the soundness of an investment on your own will protect you from dangerous investments.

Also, checking the property itself (lot, plan, layout, structure, etc.) and examining the current market are also important steps.

If you have basic knowledge of investment analyses and inspect properties on your own, I believe that you will notice suspicious sales talk and keep yourself out of harm's way.

Keep your risks at a minimum by improving your own real estate investment literacy.

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