When deciding on what approach to take when it comes to property valuation, the details of your property acquisition, the equity investment, and the real property sale will be highly influenced.
As a real estate investor, you need to be aware of the amount of money you will need to purchase a real estate property. The process of coming up with the price of a real estate property is known as property valuation or real estate appraisal.
What Is Property Valuation?
Property valuation describes the process of coming up with the economic value of an investment property. The process tries to come up with a fair market value for a real estate property or the right price at which an informed seller will be willing to sell their real estate property to an informed buyer. This means both the buyer and seller have the required information, and both sides are willing to sell and buy.
However, you must remember that the property value may not always equal its price. There are some cases where a desperate seller wants the sale to happen immediately, even if the selling price is below the fair market value of the real estate investment.
Importance of Property Valuation
Property valuation is key in real estate investing since it is a major factor in determining the amount of property taxes and property insurance to be paid. Additionally, mortgage lenders usually demand a home appraisal before approving a loan.
They do this to protect potential buyers from overpaying for a real estate property and the bank from financing an investment property worth less than the investment the bank is putting in. Home appraisals can also settle legal issues like divorce, a lawsuit, or a real estate settlement.
How to Carry Out Property Valuation
A professional certified appraiser normally carries out property valuation. However, real estate investors may decide to do the property valuation by themselves.
The cost of carrying out property valuation may vary depending on the size of the property. It may range from $300 to $400, but sometimes this figure may be more. Here are the most common approaches used in property valuation.
Income Approach
The income approach is mostly used in property valuation when dealing with commercial real estate and rental property. The income approach is achieved by calculating the current value of the property formulated on the net income generated by the real estate investment divided by the capitalization rate.
The appraiser starts by collecting income and expense statements from that particular real estate business and from neighboring real estate properties similar to the property in question to help estimate the net operating income.
When estimating the net operating income, you need to divide the stages into four.
- Estimating the gross potential income: The aggregate income a real estate property can produce with complete occupancy.
- Approximate the effective gross income: It is achieved by estimating the vacancy costs based on similar properties in the neighborhood. The figure arrived at reflects the loss of income occasioned by probable vacancies.
- Estimate the expenses incurred by the property: Expenses can be classified into fixed and variable expenses. Fixed expenses do not change with time, including mortgage payments and property tax. Other expenses, such as management fees, utilities, and so on, are referred to as variable expenses.
- Calculating net operating income: It is done by deducting estimated expenses from the gross income.
The next phase will be to choose the most appropriate cap rate. The cap rate is estimated using market sales of similar properties that have recently been sold.
Capitalization Rate
One of the most critical assumptions a real estate investor makes when carrying out real estate valuation is choosing the most appropriate capitalization rate—also known as the cap rate.
The cap rate is the requisite rate of return on real property, net of appreciation or depreciation value. In simple terms, it is the rate used on net operating income to determine the current value of a real estate property.
Sales Comparison Approach
It is also referred to as the market approach. This approach depends heavily on the current sales data for similar properties. By looking for recently sold buildings that have identical properties and are from the same market environment, the buyer is trying to confirm the fair market value of that particular property.
When using the sales comparison approach, you will have to adjust to some differences since no two properties will look completely alike. To create a proper adjustment while comparing properties, a real estate valuer should understand the difference between comparable properties and how to evaluate the differences.
While this approach is typically used in residential real estate valuation, it has one key drawback. Depending on the local market, it may be challenging to find current, comparable properties that are similar to that specific real estate.
The sales comparison approach is mostly used to get the home value for single-family homes with similar real estate properties to compare.
The Cost Approach
The cost approach determines the property value by considering the land cost, adding the construction costs less physical and functional depreciation. This method is commonly used to evaluate properties that are not sold easily, such as hospitals, government buildings, and schools.
The cost approach is normally used when it is difficult to get appropriate comparable properties, especially when the real estate property has undergone specific modifications or if the upgraded structures have substantially increased the value of the underlying land.
The sales comparison approach can be used to estimate the land cost by examining recent land sales near the subject property, which should be similar in size and location.
There are different ways of coming up with replacement costs; the most popular one is finding out the cost of building a square foot of comparable real estate property and multiplying it by the total square footage of the whole building.
This property valuation approach can work independently; however, for commercial real estate, you will get a more accurate result using supplementary valuation. Such properties have expenses and cash flow that need to be considered.
Gross Income Multiplier
It is a relative valuation approach based on the assumption that real properties in the same neighborhood will be valued equivalently to the gross income they produce.
As the name suggests, gross income refers to the total income generated before any expense is deducted. However, vacancy rates need to be forecasted to estimate an accurate gross income.
The next phase when assessing the value of a real estate property is to establish the gross income multiplier, which will be multiplied by the gross annual income. You can use historical sales data to obtain the gross income multiplier.
Dividing the selling price of comparable properties by the generated gross annual income will give you the average multiplier of that particular region.
Factors That Hinder Property Valuation
All the above-mentioned approaches to property valuation may appear simple in theory, but when it comes to practicality, it might pose a challenge to determine the value of a real estate investment that generates income.
It may be demanding and time-consuming to obtain all the needed information related to the formula inputs, like net operating income, capitalization rate premiums, and comparable sales data.
Secondly, the valuation methods do not adequately factor in the possibility of the real estate market changing. The changes may include a credit crisis or a real estate market surge. This means that more analysis needs to be done to predict and factor in the possible impact that might be felt caused by the changing economic times.
Unlike the stock market, property markets are not liquid and transparent. It is difficult to get the needed information to make an informed decision concerning your real estate investment.
When all is said and done, because of the huge capital investment needed to develop a large investment, this complex analysis can generate a large payoff, especially if you get an undervalued real estate property. Therefore, it is beneficial to spend your time and energy searching for all the necessary input.
Bottom Line
The decision concerning what method of property valuation will depend on the particulars of your property purchase, real property sale, and equity investment. As a commercial property investor, it is advisable to always use the income approach, or you can combine income, sales, and cost approaches.
Commercial real estate property is an income-generating investment machine. The business operations of the property are equally important, just like the property’s physical location, building structure, and features.
