Learning how to find the value of a property is important when it comes to real estate investing. Real estate valuation comes in handy when purchasing or selling an investment property, as well as for taxation and property insurance purposes. In this blog, we will explain the different property valuation methods that are most common in real estate investing.
What Is Property Valuation?
The process in which the economic value of a real estate property is determined is called property valuation, or property appraisal. Property valuation aims to find the fair market value of a real estate property. In real estate economic terms, fair market value is the price at which an informed property seller willingly transfers ownership of a property to an informed buyer.
Property valuation is mostly conducted by professional real estate appraisers as banks and money lenders ask for a professional real estate appraisal for mortgages. Knowing the exact value of the investment property protects lenders from giving a loan greater than the property’s value.
When buying an investment property, one should make sure that he/she is not paying for the property above the market value. Doing so would greatly affect your return on investment. For that, you need to be able to identify real estate comps and learn how to find the value of a property.
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How to Find the Value of a Property: 3 Ways
The Income Approach
The income approach, also known as the net operating income method, is a real estate valuation method that uses the rental income generated by an investment property to estimate its value. This property valuation method is most common in commercial real estate and for rental properties where rental income data is available.
The income approach method uses the net present value of future cash flows, known as discounted cash flow analysis, to determine the value of a rental property. The discounted cash flow is then capitalized in conjunction with other factors to calculate the value of the property on the current market.
There are multiple methods to capitalize future income of a rental property. The simplest one and the one we are going to focus on is the direct capitalization method. An advantage of using direct capitalization is that it provides a quick estimate of property value. A market multiplier, or a cap rate, can be easily obtained from recently sold real estate comps.
Property Value = NOI/Cap Rate
To estimate the net operating income, a real estate investor can break down the procedure into 4 steps:
1- Calculate the gross potential income, which is the maximum rental income a rental property can generate assuming 100% occupancy rate.
2- Calculate the effective gross income, which takes into account the loss of income due to vacancies. Knowledge of the local real estate market or rental data will help you estimate the vacancy rates of comparable rental properties.
3- Calculate NOI by subtracting property expenses from the effective gross income. Investment property expenses include fixed costs such as property taxes and mortgage payments, as well as variable costs such as property management fees and maintenance costs.
4- The last step is to choose an appropriate cap rate to use in the valuation formula. The easiest way to do that is by using cap rates of recently sold real estate comps. A comparative market analysis is a good way to start when choosing a cap rate.
The Sales Comparison Approach
The sales comparison approach (SCA) is a real estate valuation method that compares recently sold similar properties within the same area to the subject investment property. Adjustments are then made to account for differences since no two investment properties are exactly identical.
The sales comparison approach uses comparative market analysis to determine the current value of a real estate property. A list of recently sold comparable properties within a close distance from the investment property in question is made and the average price per square foot is calculated.
To be considered as a real estate comparable, the properties should be as similar to the subject investment property as possible: same size, same number of bedrooms, same property type, same age, and building condition.
The Cost Approach (Less common for residential real estate)
The cost approach is less common when valuating rental properties. Knowing how to find the value of a property using the cost approach is useful when valuating real estate properties that are not easily sold, like old buildings. The logic behind this approach is that the value of an investment property is the sum of the land value plus the cost of replacing the property, minus the physical degradation and functional depreciation.
Estimating land value can be done using the previous approach- by looking for recently sold land that is comparable in size and location. As for replacement costs, the most common method is to estimate the cost to build a square foot of comparable investment properties.
How to Find the Value of a Property: Mashvisor Can Help
While Mashvisor does not offer real estate appraisal services, we can surely help you when it comes to learning how to find the value of a property. Mashvisor’s rental property calculator and real estate investment tools are a great source when looking for cap rates and other rental data (occupancy rate, listing price, rental income, etc.) for real estate comps. Moreover, when choosing an investment property to analyze, Mashvisor gives you access to real estate comparables that match that property.