NJ Forensic Accountant Discusses Real Estate Investments

Video Transcript 

My name's Robert Bonavito, New Jersey Forensic Accountant. This video is part of a series of videos where I discuss Forensic Accounting topics for educational purposes only. If this was a litigated matter, I would take a different approach, have different conclusions, based on different facts and circumstances.

Hi, my name is Robert Bonavito, New Jersey Forensic Accountant. We have a lot of cases in our firm that involve real estate, sometimes individuals, sometimes corporations, co-ops and stuff like that. And I'm just going to talk a little bit about understanding real estate, and what most people don't understand about real estate is generally real estate appreciates at the rate of inflation. And you're saying, "Well, how could that be? My uncle bought the house for $1,000 20 years ago and sold it for 500,000."

Well, most of the times if you just take the rate of inflation, you'll figure out that the increase in the house value was really the result of just rising prices. It wasn't anything else. Now, of course, location, location, location. You could have a piece of real estate that appreciates a lot. But generally, when you look at a house or a home, they're not great investments. It's a great home, but it's not a great investment. And what do I mean by that? Well, if you buy a house, first of all, you're buying a house at fair market value right? You have closing costs when you buy it and when you sell it you have closing costs. So going in and out of the transaction you have costs. And what do you have between the date you buy it and the date you sell it? You have real estate taxes that are going up, 5 or 6% a year. You have maintenance costs that are usually 3 to 4% of the investment. And if you actually ever sat down and looked at it, it's not a great investment, especially compared to stocks and bonds and stuff like that, usually. But if you buy an apartment building, you put sweat equity in there and it's in a good location, you can make a lot of money.

But the way we think about real estate is we look at the rate of inflation and that's the increase. For example in 2000, from 2000 to 2015, most houses appreciated by 0.2% over those years, annually and the reason is because that was the rate of inflation. The inflation was way under 1% during that period. And we use these in our calculations a lot. Let me just go through a quick analysis for you. Let's assume we buy a small apartment building for $5 million, and we expect to get $100,000 a year for 30 years, increasing at 5% a year. So, for example, in Year 1, my net cash flow from this 5 million-dollar-investment is going to be $100,000, in the next year it's going to be 105,000 and every year after that I expect my cash flow to increase by 5% for 30 years. So I have a pretty complex...well, not a complex problem, but I have an apartment I bought for 5 million and I want to know what the value is 30 years from now. How do I figure that out? Not that hard really. Okay, if I know the rate of inflation, okay, I can just...what I'm going to do is just divide this by 1.025 to the 30th power, and what that's going to give me, it's going to...this, I'm going to travel forward in time to 30 years. It's going to be worth $10,486,000, 10 years from now just because in most cases real estate appreciates by the rate of inflation.

Now I have 30 payments increasing at 5%, right? What's the net cash flow of that? Well, I could figure out what the future cash flow is then I'm going to take it back and that comes to 2 million...that comes to 3 million dollars about. Let's say 3 million. Okay, the net present value of the $100,000 over 30 years is about 3 million. In the future, my real estate is going to be worth 10 million. I then what? I need to see what it's worth now. I just discount this the same way I discounted the cash to get a present value. That value is going to be a little bit over 2 million. It's going to be 2.4 million, okay? So I know I'm going to spend $5 million now and the net present value of the appreciation plus those payments is going to be $5.4 million. So I probably should make this investment as long as I'm willing to wait 30 years because I'm going to make $400,000. You know maybe you might not if you have better alternatives.

But these calculations are what we do in most cases and if you look at something like the S&P 500 Shiller Index which tracks real estate, you'll see that most real estate is just appreciating at the rate of inflation. So if you buy a house, you could probably figure out what it's worth in the future. And if you have a really good location, maybe it will be twice or three times that, but generally, throughout the United States, it will be appreciating at the rate of inflation.

My name is Robert Bonavito. If you have any questions on this video, feel free to email me.