Identifying your property’s value is crucial. As a real estate investor, you need to be aware of the three ways to determine the value of your real estate investments to guide you with your purchase, justify your selling price, or simply learn the basic market valuation techniques.
Sales Comparables
The most popular method is sales comparables or more formally known as comparative market analysis. In this method, sales information about properties that were sold within the last three to six months as well as those that comprise the list of pending sales in the neighborhood are compared.
Since the goal is to determine a property’s fair market value (the fair price of a home that a ready, willing and able buyer is able to offer and a seller is willing to accept), it requires expertise in selecting homes that are similar in size, amenities and condition, which only a real estate professional can do best given his or her familiarity with the local market.
In analyzing comparables or comps, the property with the most similarities to yours and that was most recently sold, is closest to the actual market value of the home.
A typical comparative market analysis consists of the address of the properties to be compared, selling date, sales price, size, number of bedrooms and bathrooms, parking slots, general condition of the house and a few remarks by the real estate agent. Although comparables provide almost similar prices, such analysis cannot usually account for the differences among properties in terms of exact location and wear and tear. In addition, the lack of similar homes that were recently sold in a neighborhood can be a problem when coming up with a comparative market analysis.
Capitalization Rate
Another method is capitalization rate or cap rate, for short. It is the ratio used to identify the value of a real estate investment and given by the following formula:
Capitalization Rate = Net Operating Income / Market Value
To begin with, you must identify the net operating income which is simply the gross income of the property less operating expenses such as taxes, insurance, maintenance costs, etc. Take note that mortgage payments and improvement costs are not part of operating expenses. From this, you can start determining the cap rate of a real estate investment. (For a more detailed explanation read our post: Estimating Value with the Capitalization Rate)
Real estate brokers and appraisers often prefer to use the cap rate when talking with their clients. That’s because the net operating income and the value of recently sold properties are used to come up with an estimate of the purchase price for the real estate investment.
An advantage of using the cap rate method is that it incorporates a number of elements in the computation such as operating expenses, non-rental income, gross rent and amount of vacancy aside, of course, from the property’s selling price. For a real estate investor, the ideal properties would be those that have higher cap rate.
A disadvantage of the cap rate method is that it becomes unreliable when there are no qualified properties to use as a comparison and the real estate agent or appraiser has to find other properties to make up for the missing data.
Replacement Cost
Finally, the replacement cost method determines the value of a real estate investment by estimating the cost of replacing the improvements on the land, and then adding the value of the land to come up with the total market value.
To do this, you must multiply the entire square footage of the structure by the current construction cost for the area. This can differ greatly from market to market, and even between neighboring zip codes.
Like other methods, the replacement cost technique can be affected by market conditions. For example, in periods of rapid inflation, construction costs are high and will impact replacement cost values.
These three methods can help any real estate investor determine a property’s value, however, the credibility of the results must be considered when selecting which technique to use for your real estate investment.
