When it comes to real estate investing, it is important to learn how to determine property value. Real estate appraisal is the professional form of property valuation, where a licensed real estate appraiser develops an opinion of value for the real estate property. While real estate appraisals are required for real estate transactions such as mortgage applications or for property tax purposes, any real estate investor is free to determine property value for decision-making purposes. In this blog, we will show you how to determine property value using 3 methods.
What Is Property Valuation?
Property valuation is the process that determines the economic value of a real estate investment. This value is called the fair market value, where an informed seller agrees to sell his/her real estate property to an informed buyer. Fair market value assumes that both parties have all the relevant information and neither side is forced to buy or sell unwillingly. However, a property’s price, or its market value, can differ from its real value and cost. Basically, the cost of a property refers to the construction costs plus land cost. While not always true, selling prices of properties often reflect current home values, as they both express the opinion of buyers.
Determine Property Value: Why Is It Important?
Whether you a real estate investor or a homeowner looking to sell your real estate property, you definitely need to know how to determine property value. Evaluating real estate property is required to calculate property taxes and home insurance. Furthermore, lenders require a professional home appraisal before approving a mortgage loan. While these appraisals need to be done by a licensed real estate appraiser, which costs around $300-$400 for a single family home, any real estate investor can determine property value to assess different real estate deals.
Is the seller asking for too much? What is my property worth? How much rent should I charge? Property valuation can help you answer all these questions. The following methods are the most common approaches to determine property value.
Related: How Much Can I Rent My House for?
#1 The Income Capitalization Approach
The income approach is a type of real estate valuation method that allows property investors to determine property value based on the net operating income (NOI) that a property generates. Therefore, this method is particularly common in valuating rental properties. In this approach, the value of a real estate property is calculated by dividing the NOI by the capitalization rate.
Property value = NOI / CAP rate
The capitalization rate, or cap rate, is a real estate metric that expresses the profitability of an investment. It is often used by real estate investors to compare several investment opportunities to make well-informed investment decisions. So, how to determine cap rate to evaluate a rental property? CAP rate can be estimated using market sales of rental comps. Rental comps are properties in proximity to the rental property in question, that also share certain physical features such as square footage, number of rooms and bedrooms, and special amenities.
Related: What Is Cap Rate in Real Estate Investing? A Simple Guide
Net operating income is calculated following these 4 steps:
1- Calculate gross potential income (GPI): rental income assuming 100% occupancy rate.
2- Calculate effective gross income (EGI): by conducting real estate market research, you can estimate the vacancy rates of rental comps. EGI = GPI – average vacancy cost
3- Estimate property expenses: fixed property expenses are those that do not change with time such as property taxes and mortgage payments. Other expenses, like property management fees and maintenance costs, are called variable costs.
4- NOI = EGI – property expenses.
Now that you have estimated both NOI and CAP rate, you can easily determine property value.
Tip: Using an investment property calculator provides you with CAP rates of rental comps. Check out Mashvisor’s rental property calculator.
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#2 The Sales Comparison Approach
The sales comparison approach is the basis of what is known in real estate as comparative market analysis, CMA. Comparative market analysis uses recent sales data of comparable properties in the same area to estimate the value of a real estate property. Real estate agents, appraisers and investors alike, use the sales comparison approach to determine property value.
To qualify as a comparable property, there are some basic requirements:
1- The comparable property should be as close as possible to the subject property.
2- The selling date should be as recent as possible. Move a little farther out if you can’t find comparable properties within that range.
3- The comparable properties should have similar physical features. i.e. square footage, number of rooms, and lot size. Comps should always be of the same type. For example, do not compare single family homes to apartments.
Since it’s uncommon for real estate properties to be exactly the same, adjustments have to be made to account for differences in properties. An experienced real estate investor or a real estate appraiser knows how to value these differences for a more precise valuation.
Related: Learn How to Evaluate Multi Family Investment Properties
#3 The Cost Approach
The cost approach is used to determine property value based on the cost of replacing the property plus the cost of land. This method is the least used method when it comes to valuating real estate. However, it can be useful to estimate the value of properties with a market, like schools, hospitals, and government buildings.
When using this method, comparable properties of the same type are used estimate construction cost. How much does it cost to build one square meter? The average is then multiplied by the area of the subject property. Land cost is estimated using the same logic: a list of recently sold comparable land is made and the average price is used.
The Bottom Line
Whether you are an investor looking for a real estate property to buy or a homeowner who wants to sell his/her property, knowing how to determine property value is important to guarantee not paying too much or selling for too low.
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