What Values Do You Need To Know When Investing?

Years ago I learned appraisers and other property valuation folks use three methods to build a value for a piece of property. The sales comparable or market approach basically look at what comparable properties sell for, the cost approach looks at what it would cost to build the property, and the income approach considers the value of the income stream that a property generates or could generate. Each of these methods has a different use and different type of property for which it is most appropriate. Let me share a little more detail before giving a slightly different investor focused concept.

Comparable Sales Approach

In the comparable sales approach, a value is created by looking at what similar properties in a similar market have sold for. Your REIAComps.com Membership is very useful here. For example, if three similar three-bedroom homes sold in the same neighborhood in a range of $75,000 to $85,000, it’s reasonable to assume that a comparable property would also sell in that range. The appraiser would choose a specific value by adjusting each comp for the unique characteristics of the property that they are analyzing. You can get assistance performing this same comparable analysis by using the Valuation Support Desk through your REIAComps.com Membership.

Cost Approach

The cost approach values properties on the basis of what it would cost to build them today. The valuation starts by estimating the cost for labor and materials to either build a comparable replacement building or to completely reproduce the building, depending on the scope of the analysis. Next, the appraiser subtracts out an estimate of the building’s loss of value due to depreciation since the building being analyzed is probably not in the same condition as a newly constructed property.

Income Approach

The income approach values properties based on the income that they could possibly produce. Typically, the analysis starts with calculating a net operating income for the property that takes its rent and its operating expenses into account. Next, the investor conducting the analysis chooses a capitalization rate, which is an income multiplier. The cap rate is usually derived from comparable sales data. The price gets calculated by dividing the NOI by the cap rate. For example, if a property has a $40,000 NOI and comparable buildings trade at a 7 percent cap rate, it would be worth $571,428. The price comes from dividing the property’s $40,000 income by 0.07, which is the market cap rate. If the market cap rate was 8 percent, the property would be worth $500,000 (50000 / 0.08).

Choosing an Approach

Each approach has different uses. The income approach typically gets used for rental and income producing properties like duplexes up to eight bedroom apartments. Most cost approach analyses are done with newly constructed properties because there is less depreciation to calculate. Unique properties for which it is hard to find comparable properties, like specialized vacation properties or industrial buildings, are also good candidates for the cost approach. The sale comparable approach is typically used for properties like single family residences where many comparable sales from which to choose exist.

Now the real fruit on the tree is you always want to calculate two numbers. The acquisition value as well as the after repair value (ARV). As investors, we want to have a solid idea of not just the value of a dwelling.  Because we are proactive in our business acumen thinking of the next individual in the transaction, it is vital to demonstrate there is an equity position for the buyer. Use your REIAComps.com account to determine the best acquisition and ARV every deal you look at. Don’t for one moment let someone tell you the value. Let REIAComps.com show you for yourself.