Valuing a property is one of the first steps to making a real estate investment decision. The property’s valuation is foundational to assessing the return on investment a real estate investor can expect from a deal.
For a real estate investor, it helps to learn how to assess a property value yourself even if it’s a back of the envelope calculation. Doing so can quickly tell you if a property is over- or under-valued, and whether or not it looks like a deal worth pursuing further.
Since the real estate market isn’t as liquid or transparent as the stock market, there are three primary methods of valuing a property. These methods are sales comparison, replacement cost, and income. Each method has a specific use case.
Methods of Property Valuation
Sales Comparison Method
The sales comparison method is exactly what it sounds like: valuing a property based on sales data from comparable properties in the past twelve months. Aspects included in the comparison are location, size, style, age, and condition. In the residential real estate market, many houses in the same neighborhood are similar in design and build year, making “comps” data usually easy to gather.
Prices that comps sold for help determine the Fair Market Value (FMV) of a property. The FMV is the price a fully-informed buyer would expect to pay for a property. If you’re looking at a property priced at $150k, and comps have sold at $200k, this is a good sign that you may have found a sweet deal.
Note: Real estate agents are typically the ones pulling comp data. If you aren’t using a real estate agent, here are some independent sites you can use Black Knight, Clear Capital, and Zillow.
Replacement Cost Method
For one-of-a-kind properties or those without reliable comps, use the replacement cost method. This method factors in the cost of the land the property occupies plus the cost of replacing the property itself. Uncommon properties such as a converted church or factory won’t have accurate comparisons to measure against since part of the appeal is in the uniqueness of the property.
When dealing with properties like this, it’s a good idea to hire an appraiser. They will factor in land cost, building costs, depreciation, and any functional or economic obsolescence. Luckily, getting an appraisal isn’t very expensive, typically $300-600 depending on the size of the property and the type of report needed.
Income Method
The income method to valuing a property comes down to its net operating income (NOI) and the capitalization rate. This method primarily views properties as revenue-generating rental properties.
To calculate the NOI for a property, find the effective gross income (total gross income minus estimated vacancy costs) and subtract the annual fixed (taxes, mortgage) and estimated variable expenses (management fees, repairs).
The capitalization rate, or cap rate, is a relationship between the NOI and the property value. When valuing a property though, the cap rate can be found by looking at comparable properties or by estimating the expected rate of return. Often, cap rates are estimated by real estate investors or property appraisers.
Then, take the NOI and divide it by the cap rate.
NOI/CAP RATE = Property Value
Example:
NOI = $20,000
Cap Rate = 10%
$20,000 / .10 = $200,000
Property value = $200,000
How to assess a property value can come down to your personal preference or the specific need of the situation. The income approach is popular with house flippers and buy-and-hold real estate investors since they intend to use the property to generate income.
The 70% Rule
There is one more rule-of-thumb when assessing a property’s value, though the 70% rule isn’t exactly used to value a property. The 70% rule states that house-flippers should offer approximately 70% of a home’s after repair value (ARV) to purchase it. They can deduce the ARV by viewing the home and estimating renovation costs and by checking out comparable homes, as well.
House-flippers should be familiar with this rule and be able to calculate it easily.
Whether you’re looking into commercial or residential real estate, knowing how to assess a property value is a valuable tool in your investor’s toolkit. To learn more helpful tips on real estate investing, check out our previous blog posts.