When it comes to real estate investing, the first thing that comes to a real estate investor’s mind is how much money he/she should pay for a certain real estate property. Pricing a real estate property is called property valuation, or real estate appraisal. In this blog we provide you with 3 main property valuation methods for real estate investors.
What is property valuation?
Property valuation is the process in which the economic value of a real estate investment is determined, which often seeks to determine the fair market value of a real estate property, or the price at which an informed seller willingly sells his/her real estate property to an informed buyer. In other words, both parties have all the relevant information, and neither side is forced to sell or buy. However, it is important to point out that a property’s value is not always equal to its price. For example, in some cases a seller is distressed and must sell the property right away even if the price is below its fair market value.
Why is property valuation important?
Property valuation is a very important concept in real estate investing because it is the main factor that determines how much property taxes and property insurance to pay. In addition, mortgage lenders require a home appraisal before providing a loan. The reason for this is to protect the potential buyer from paying too much for a real estate property, as well as protecting the bank from financing a property that is worth less than the amount it invests in. Home appraisals are also required to settle down legal matters such as divorce, real estate settlement, or a lawsuit.
How to do a property valuation and how much does it cost?
A property valuation is usually performed by a professional certified appraiser, but a real estate investor can perform his/her own property valuation. On average, the cost of a home appraisal for a single-family home ranges between $300 and 400$, but it can increase depending on the size of the property. The following methods are the three most common approaches for property valuation.
1- The Income Approach
The income approach is a property valuation method that is particularly common in commercial real estate and rental properties. The main idea behind the income approach is to calculate the current value of a real estate property based on the net income it generates divided by the capitalization rate.
As a start, the appraiser needs to collect income and expenses statements for the subject real estate property and for similar properties in the same area in order to estimate the net operating income. Estimating the net operating income (NOI) is broken down into four steps:
1- Estimate the gross potential income: The total income a real estate property generates with a 100% occupancy.
2- Estimate the effective gross income: Simply done by estimating vacancy costs based on similar properties in the local area. This figure reflects the normal loss of income caused by probable vacancies.
3- Estimate property expenses: Expenses fall into two categories: fixed and variable expenses. Fixed expenses are expenses that do not change with time, like property taxes and mortgage payments. Variable expenses are all the other expenses such as utilities, management fees, and so on.
4- Calculate NOI: By subtracting the estimated expenses from the effective gross income.
The next step would be choosing an appropriate cap rate. A real estate investor or a property appraiser estimates cap rate using market sales of comparable properties that have been sold recently. (A property with a NOI of $20,000 that sells for $200,000 has a CAP rate of 10%).
PROPERTY VALUE = NOI/CAP RATE
Related: If you are interesting in learning more about what is a good a cap rate, make sure to read this blog “What’s a Good Cap Rate for Investment Properties?“
2- The Sales Comparison Approach
As the name suggests, the sales comparison approach uses the market data of sale prices to estimate the value of a real estate property. Property valuation in this method is done by comparing a property to other similar properties that have been recently sold. Comparable properties, also known as comparables, or comps, must share certain features with the property in question. Some of these include physical features such as square footage, number of rooms, condition, and age of the building; however, the most important factor is no doubt the location of the property.
Adjustments are usually needed to account for differences as no two properties are exactly the same. To make proper adjustments when comparing properties, real estate appraisers must know the differences between the comparable properties and how to value these differences.
The sales comparison approach is commonly used for single family homes where there are typically many comparables available to analyze.
Mashvisor can help you locate real estate comps within any real estate market in the US.
3- The Cost Approach
The cost approach is a real estate property valuation method which considers the value of a property as the cost of the land plus the cost of replacing the property (construction costs) minus the physical and functional depreciation. This approach is most commonly used for real estate properties that are not easily sold like schools, hospitals, and government buildings.
Land cost can be estimated using the sales comparison approach by studying recent sales of land close to the subject property, and these sales should be comparable in size and location. There are different ways to estimate replacement costs, the most common being finding out the cost to build a square foot of comparable properties multiplied by the total square footage of the building.
The Bottom Line
These three property valuation methods are the most commonly used ones to valuate a real estate property. Choosing the best method out of them depends on the type and use of property and the availability of information.
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