In the real estate market, determining property values is a complicated process. Understanding how to value investment properties is key to your portfolio performance. Since real estate is generally less liquid than other assets, there are many factors that go into determining whether a property is worth its asking price or not. We will walk you through the three most common property valuation methods and what exactly goes into evaluating your property value so that you can get the most money out of your investments, whether buying or selling.
What is Property Value?
Property value is the amount of money that a property would sell for on the market today. The value of your property is based on many factors including its location, size, condition, and amenities. A property’s value is also affected by the real estate market cycle and economic cycles which impact housing demand.
There are two schools of thought on how to determine property values: intrinsic value theory and market value theory. Intrinsic value theory states that each property has an intrinsic worth since all properties serve a functional purpose (i.e., they are homes or commercial buildings). Contrarily, Market Value Theory states that there is no such thing as an intrinsic worth because all properties have only relative values which depend on supply/demand factors within their geographic area and general economic conditions at any given time.
To succeed in the investment world, you must consider both market value and intrinsic value. The central objective when finding good investments is finding projects where the market value is undervalued, or beneath, the believed intrinsic value of the property. Finding this difference is key to finding good projects and to comparing investment opportunities. When those properties are found, strong negotiation can bring the property price to fair market value.
How Property Value is Determined
There are three main methods to value investment properties: a sales comparison, cost-to-replace, and income. Each method considers the following factors:
- Current market conditions and trends
- Building structure, age, condition, and size
- Location (proximity to schools, shopping centers and parks)
- Features (garage size, number of bedrooms)
Getting Second Opinions Through Appraisals
The appraisal process is a detailed and thorough procedure that appraisers use to determine how to value investment properties. Appraisals are used for property loans, property tax assessments, and refinancing purposes. Additionally, investors can hire an appraiser to get a second opinion on their valuation of the property and what it should be worth for a more accurate forecast.
The two most common methods are direct and indirect. A direct appraisal is when an appraiser goes out and looks at the property in person, taking note of its condition. A client will pay for this service, which can be costly depending on the size of the area being appraised. An indirect method is when a third party collects information about a property from sources such as public records or media reports before contacting an appraiser to do an analysis based on that data.
The process starts by gathering information about properties within your area; then it’s up to you to decide whether you want to use one method over another—or even combine them together!
Sales Comparison Method
The comparison method of property valuation is most used by realtors in residential-class properties. The idea behind this method is that properties that are similar in size, location, amenities, and age will hold similar value. You should look at the sales prices of similar properties to determine the value of a property.
When using this method, you must have a multitude (at least 3) of similar sales to make it work properly. Otherwise, outliers could skew your perception of a fair purchase price. Using an agent who has experience with appraisals will also give you an advantage when using this method because they know what makes a good comparable sale when appraising your home. Each comparable sale should be relatively recent (within 6 months or so). If it’s older than that, consider whether there were extenuating circumstances at play during its transaction (such as a recession or new development) that might skew its data out of whack with what’s happening today.
Pros and Cons of Comparison Methods
The main advantages to using the comparison method are: It’s relatively easy to use; it’s inexpensive; there are no special skills required (aside from knowing how much money was paid for a comparable home). Any person can understand how it works since all you do is compare two different properties based on their features and characteristics instead of trying something new like estimating market trends or building complicated financial models which could be difficult for people who want to invest in real estate but lacks accounting knowledge or computer savvy skills needed for making these kinds of calculations correctly.
There are some disadvantages, however. First and foremost, the comparison method is great for determining what other people are willing to pay but it fails in telling you a price for a sound investment. When comparing investment opportunities it is best to use other approaches in conjunction. Additionally, truly unique properties will not have enough sales data for predicting the market value of a property, which is why this method is used mostly for single-family units as it is easy to replicate. You also will need access to records showing recent selling prices for comparable houses nearby yours, so access to databases such as the Multiple Listing Service becomes more important.
Income Method (Capitalization Rate)
The income approach is used to value a property that is leased or will be leased. This method can be applied to any real estate sector but is most common on investment properties such as apartment complexes, office buildings, retail stores, and industrial properties.
The income approach is more objective than the comparable sales approach because it does not rely on market conditions at the time of valuation. Instead, it relies on tangible data (i.e., rent rolls and tax returns). With this data, the property’s current income, expenses, and net operating income are used to derive its value by finding the capitalization rate (cap rate).
The capitalization rate is the gold standard for investment property values. The cap rate for the property may be found by dividing the net operating income (NOI) by the sales price or purchase price plus improvements:
Capitalization Rate = Net Operating Income / Asking Price + Improvements
Net Operating Income = Lease Revenue – Vacancy Loss – Operating Expenses
Pros and Cons of the Income Method
The income method is used extensively regardless of investment strategy or investment portfolios main difference between using this method versus comparing properties in your area is that you don’t use data from other similar properties in other areas as your basis for comparison, at least not yet; instead, you must use only financial data from the specific property in question. This makes this method more difficult than simply running comps across different markets as you need the actual documents telling the true story of the asset’s performance. However, if done correctly, it will give an accurate representation of a property’s NOI.
Before making an actual offer, you will need to see comparable sales of the property to see what cap rate those properties offered. Cap rates are what fluctuate with the real estate market cycle. By applying the market cap rate, you can find the fair market value of a property. Contrarily, if you have an investment threshold requirement like we do at Eikon Investment Group, you can apply your desired cap rate, visualize the difference, and see if a property is worth further consideration.
Fair Market Price = Net Operating Income / Market Capitalization Rate
Although this method is more difficult to implement, the income approach provides data based on the concrete performance of the building rather than the subjective feelings present in an unleased single-family unit.
Cost Replacement Method
The cost approach is used to estimate the market value of a property by determining the cost of its reproduction. This method is useful in appraising properties that are unique, or very specialized. The cost approach is also useful for determining fair market values when the income capitalization method cannot be used due to a lack of comparable sales data (e.g., vacant or partially developed land).
The most common use of this method occurs in development strategies and value-add strategies. It can also be applied where there have been extensive improvements made on property since its initial construction period, or when there have been substantial renovations made within an existing structure over time (for example, strip mall tenants may each experience their own upgrades over time). In these cases, both historical costs along with projected costs for future improvements should be included to capture all relevant factors affecting current market value under this methodology; doing so will ensure more accurate results than simply estimating future profitability based on past performance alone!
Pros and Cons of the Cost Replacement Method
While the cost replacement method is the most effective technique for valuing a unique or specialized property, the primary disadvantage associated with using this technique lies within its inherent complexity. Cost replacement analysis does not require expensive specialist skills such as financial statement analysis; instead, it relies on general knowledge about construction costs and prices paid for materials and labor at a particular time and place. Consequently, a cost-replacement analysis uses data from multiple sources (e.g., building permit records, labor rates, contractor pricing) rather than just one source such as real estate sales reports. An investor must use careful consideration prior to deciding which hard cost or soft cost elements should be included/excluded from calculations. Properly applying these could be the difference between a profitable investment and a money pit.
3 Methods to Value Investment Properties
Each method has its own set of pros and cons so it’s important not only to know what they are but also to understand how each one affects your financial projections before making any decisions regarding which properties should be included in these equations. In summation:
- The sales comparison method is based on what similar properties have sold for recently in the area and is great for dictating true market values. The sales comparison method is the most used method, partly because it is relatively simple and can be applied by someone without extensive training or experience in real estate appraisal. The appraiser compares recently sold properties that are like your property, adjusting for factors such as differences in size, location, and condition.
- The income appraisal method analyzes a building’s income-generating potential by looking at expenses like operating costs and vacancy rates with expected returns on investment over time through rental contracts (or mortgages). A shortcoming of this method is that it requires more information than just what price a comparable building might go for—you also need information about current trends in rental rates so you know whether yours will eventually make money if rented out now!
- The cost replacement method uses building materials and labor costs as a basis for determining fair market values to figure out what you should be able to sell or buy a particular piece of real estate for. The cost approach is most useful in ground-up development investment strategies and value-add strategies as well as in cases where there are few sales transactions that match the subject property’s characteristics.
Best Method to Value Investment Properties
Three Factors to Consider to Value Investment Properties:
- One of the most important factors in making this decision is the accuracy of the results. In general, if a higher level of accuracy is desired, then more time and resources need to be spent on creating an accurate model that can capture all relevant data points for a particular property.
- Which method is most appropriate for your market? The best way to determine this is by talking with a real estate professional who is familiar with your local market. They can help you choose which valuation method will provide an accurate estimate of value in your area by using relevant data and knowledge about current trends in your community.
- How accessible are the data needed for each method? For example, if most properties in your city are new construction with no recent sales history available, then using an income-based approach or sales comparisons would be more difficult because there isn’t any reliable information on previous sales prices available that could be used as comparable.
When determining which valuation method to use, there are several factors that you should consider. Considering your financial goals, portfolio objectives, investment strategy, and asset class will help you decide which method is best for you. It is important to note that the three valuation methods are not mutually exclusive. In fact, for most real estate investors, a financial model that is a combination of all three methods may be best.
For help in evaluating your investments, you can always reach out to us at invest@eikoninvestments.com.
Happy Growth.
