Investment Ratings for Real Estate

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An investment rating of a real estate property measures the property’s risk-adjusted returns, relative to a risk-free asset. In mathematical terms, a property’s investment rating is the return a risk-free asset would have to yield to be as good an investment as the given property. The underlying drivers for property ratings are the dividends (net operating income) and capital gains over a certain holding period, and their associated risks or variances. Akin to other financial ratings such as those developed by MorningStar® for mutual funds and stocks, it can be assumed that investors have constant relative risk aversion over the wealth derived from other sources and from their investment. For simplicity, it can also be assumed that the investment return is uncorrelated with other sources of wealth but represents 100% of the investor's wealth. A property’s investment rating is then a transformation of the risk-adjusted averaged return to an intuitive number that conveys the property’s long-term potential to yield profits.

Rating could address some common pain points

For Investors

      * Finds best places to invest
      * Identifies properties with the most value
      * Establishes the right price range to pay
      * Computes rent income to expect
      * Projects long-term cash flow and appreciation
      * Connects with a local agent who knows investing
      * Assesses how to maximize after-tax returns

For sellers or listing agents

     * Calculates best price for rapid sale
     * Markets properties to a national buyer pool
     * Differentiates the value of properties
     * Instills confidence in the value of a transaction

For lenders

    * Establishes collateral value of a property (current and future)
    * Assesses size of potential loss in foreclosure
    * Simplifies decision to foreclose or modify a loan

Home as an Investment Asset

Every home is, and should be treated as, an investment asset (especially after the recent real estate downturn). But, how can one easily and objectively evaluate a property's intrinsic long-term "worth", just like other ratings have been doing for stocks and funds for several years now? Especially in these uncertain times, knowing a property's current market price is necessary, but not sufficient. It’s equally (or perhaps more) important to evaluate its long-term value.

There are hundreds of factors that could potentially impact a property's financial returns, including price appreciation, rentability and vacancy, fair market value, mortgage, maintenance expenses, property tax, property management fee if any, home insurance and more. And then, it’s a huge challenge to measure and factore in the inherent risk/volatility in all of these factors so that one can have confidence that their next home purchase is financially sound.

Some related (not directly though) real estate investment ratings

• Fitch Ratings for Residential Mortgage-Backed Securities
• S&P Ratings for Commercial Mortgage-Backed Securities
• S&P Ratings: Direct Property Fund Rating

Recently, a startup company SmartZip has started an analytics-based investment rating targeted at residential real estate, SmartZip Score, which claims to be based on a quantitative risk-adjusted evaluation of a property’s return on investment over a 10-year holding period.

See Also

• Case-Shiller S&P/Case-Shiller Home Price Index
• Predicting a Bubble in Real Estate on consequences of over reliance on past trends for future expectation.