By Hamza Abdul-Samad,
One of the most important features of owning a rental property is its value. Before we delve into the main property valuation methods, it’s imperative to understand the importance of a property’s value.
Why Property Valuation is Important
Property valuation is a key concept in real estate investing. If you don’t know the value of an investment property, you won’t be able to know how much rent to charge or how much to pay in property taxes. Estimating these two figures, along with others like property insurance, is not possible without knowing a property’s value.
So, how do you find out a property’s value? The answer is through a home appraisal. A home appraisal is a professional opinion about the value of a real estate asset at a specific point in time. An appraiser is a professional who evaluates a property’s value. The value of a rental property is known as its fair market value. Market conditions, location, and a variety of other factors influence fair market value.
Now that we’ve covered the importance of market value, it’s time to discuss the three main property valuation methods:
1. Sales Comparison Approach
The most popular of the property valuation methods is the sales comparison approach. Also known as the market data or comparable sales approach, this method is mostly used for land and residential real estate, especially single-family homes. Valuation in this method is done by comparing a real estate property with similar properties in terms of sales prices; hence the name of the method. The properties used for comparison are called comparables. Not just any properties work as comparisons, however. Properties are considered comparables only if they are very similar to the property and have been sold within the year under ordinary market conditions.
Overall, three or four comparables are used in this method. Obviously, no two comparables are exactly the same. So how can this method be more accurate?
To account for differences in comparables, some adjustments are made to sales prices. These alterations are based on other factors that influence the rental property’s market value. The most important of these factors is, you guessed it, location. Location can significantly alter the sales prices of investment properties. Physical aspects of the property also come into play. Some of these include the square footage, the number of bedrooms and bathrooms, the condition, and the interior of the income property. The age of the property is also taken into consideration, as well as the market’s conditions during the purchase. As a matter of fact, the purchase itself is analyzed, to see if the seller sold in a desperate attempt or sold to family.
2. Cost Approach
The second approach from the main property valuation methods is the cost approach. The concept of the cost approach is that a real estate investor shouldn’t buy a rental property for more than what it could cost to construct a replicate of said property. This approach uses one of the common property valuation methods, the sales comparison approach. The sales comparison approach is used to find the value of the property’s land based on comparables. Then the costs of building the property are estimated, taking depreciation into consideration.
Another aspect that separates this method from other property valuation methods is what kind of real estate it is used for. The cost approach is not used for residential or income property real estate. It’s used for properties that are usually constructed and not sold, like schools, religious institutions, government buildings, and hospitals.
Once the property’s land value is estimated, it is summed with the estimated building costs of the real estate property. Building costs can be estimated in different ways. One common way includes finding out the cost of a square foot and multiplying it by the total square footage of the comparables.
After a sum of the building costs and land value is found, the depreciation costs are subtracted. There are three types of depreciation costs. The first is physical deterioration costs, which include deterioration that can be repaired, like old paint. The second type is functional obsolescence. This refers to aspects of the property that are not desirable in the present time. Examples include low ceiling and homes with one bathroom but multiple bedrooms. The third type of depreciation is economic obsolescence, or deterrents based off location, like being next to a loud airport.
3. Income Capitalization Approach
The final approach of the property valuation methods is the income capitalization approach. This method is all for income properties. Apartment buildings, commercial real estate, and multifamily homes are examples that can be used in this approach. The income capitalization approach takes into account the return on investment and the net income of a property.
This method subdivides into two property valuation methods:
- Direct capitalization focuses on a property’s income. A property’s annual gross income is estimated. The effective gross income is then estimated by considering the impact of vacancies. From there, the net operating income is calculated after subtracting expenses. The property’s value is then estimated using the property’s capitalization rate, or cap rate, and net operating income.
- The second approach is through gross income multipliers. This method is used for real estate properties that are not initially purchased as income properties but end up being used as such. Examples include family homes. The monthly or annual gross income of the rental property is calculated. Then, the sales price of the property is divided by its rental income. This calculates the gross income multiplier, which is then used to find the property’s market value.
Knowing the main property valuation methods is vital to for real estate appraisal. While landlords and investors do not necessarily have to know the ins and outs of the property valuation methods, it’s always a good idea to have a basic idea.