Real Estate Property Valuation Guide

The value assigned to a property defines investors’ and lenders’ perceptions of it. Getting the value right is key to successful real estate investing. Use this guide to understand the principles of real estate property valuation and make a step toward more educated, informed real estate investing.

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How to Use Real Estate Valuation Methods

Certified appraisers are trained to use real estate valuation methods and prepare reports using one or all of the methods described below to provide the most accurate property value estimates. Appraisers use site visits, financial records, and data regarding other properties to generate valuations. Each state maintains a certification process for professionals in the state.

While certified appraisers provide the most accurate real estate valuations, it is not cost effective, or even possible, to get an appraisal at the earliest part of the property search process. This is where the knowledge of the valuation methods separate savvy investors from vulnerable ones.

Investors who can prepare their own valuations, even if imperfect, can quickly compare investment opportunities and avoid wasting time with overpriced properties. Ideally, an informed investor could even find an underpriced diamond in the rough.

Real estate comes in all shapes and sizes, with a variety of purposes. As a result, there are many ways to value property. This article addresses the three most common real estate property valuation methods.

1. Sales Comparison Approach

Investors familiar with the valuation of single-family homes will be most familiar with the sales comparison approach, which is known for determining value using property comparables, or “comps.”

To calculate a property’s value using this approach, research the sales price of several recently sold properties with similar features. Then, adjust the value of the subject property to the comp based on differences in size, quality, demand, and condition.

The sales comparison approach is popular because it gives buyers and sellers a valuation based on the actual data of nearby and similar properties selling in the current market. Unfortunately, there is no simple formula for this method. Instead, properties must be compared to each other, and the comparable property price is adjusted to create the subject property’s market value.

Factors Considered

A sales comparison valuation can be highly complex and account for many, many features of a property, especially if there are several recently sold similar properties nearby. Some of the major factors to consider under this valuation method include:

The age of the buildings
The overall condition and amount of deferred maintenance
Recency of comparable sales and whether any market changes occurred in the interim
Whether comparable sales were arms’-length transactions or conducted under duress
Location and any differences of lot desirability
Building size
Other building features, including construction materials and quality, finishings, flooring, landscaping, room numbers and sizes, layout efficiency, and any unique features of the properties

Advantages of the Sales Comparison Method

There is an element of ease, familiarity, and effectiveness that makes this method a tried-and-true favorite. The information needed to create a comparable-based valuation is usually fairly simple to obtain through the listing itself, the listing broker, and through relatively brief walk-throughs. Conversely, a seller who intimately knows the property can create a highly detailed valuation to most accurately price a property.

Disadvantages of the Sales Comparison Method

The sales comparison method relies on finding similar properties within a close proximity that have sold within the past year. If the subject property is unique, or at least unique to its area, the sales comparison approach can give unreliable results.

Additionally, the sales comparison method fails to capture the value of a property’s income potential, which severely curtails the usefulness of the method for investors working with income-producing rental properties.

Perhaps the greatest disadvantage is that the process is deceptively simple, leading investors to rely on skewed results from DIY valuations. Accurate sales comparison valuations require up-to-date knowledge of real estate values in a specific market

For example, adjusting for square footage differences between subject and comparable properties involves much more than tacking on or subtracting the price per square foot of the building overall. Adjustments must be made to account for above-and-below-ground areas as well as for finished and unfinished areas. This means the final square footage adjustment will actually be the result of several more specific calculations.

Investors who wish to improve the accuracy of their own sales comparison valuations can pursue valuation training unique to their market.

2. Income Capitalization Approach

Real estate retains its place as a popular investment opportunity, because investors are drawn to the potential to earn income through rental payments. Accordingly, investors may choose to rely on the income capitalization approach to assign value based on the earning potential. This is especially useful when the subject property is a multi-family housing project or commercial office space.

Put simply, this type of real estate valuation is created by dividing the net operating income by the capitalization rate. Of course, this is made more complex by the need to do calculations to get the NOI and cap rate.

NOI is calculated by subtracting all expenses from revenue. The cap rate is the NOI divided by either the purchase price or the market value of recently sold, similar comparable income properties.

Gross Income Multiplier

When a non-traditional income-producing property does not quite fit into the above calculation due to its unique factors, an alternate, income-focused valuation is the gross income multiplier (GIM). It is also referred to as the gross rent multiplier. The GIM is found by dividing the sales price by the rental income.

The resulting figure is the number of years it will take to pay off the property. However, because this uses gross rent, it does not account for expenses. GIM should only be used as a rough estimate to quickly compare properties at a glance. It does not replace a full valuation.

Advantages of the Income Capitalization Approach

This is the most effective method for capturing the value and potential of an income-producing rental property. Investors can use this figure to compare the earning potential of separate properties and to determine whether a property is a sound investment.

Disadvantages of the Income Capitalization Approach

As with the other methods, the income approach offers a limited field of view of the property’s income potential. Deferred maintenance is not included in the calculation, for instance, but it is an inevitable and significant expense when owning real estate.

3. Cost Approach

A common real estate valuation method for new-build properties and unique properties is the cost approach. It can be very effective for properties that lack closely matched comparable sales and do not generate income.

Cost approach valuations are calculated by adding the cost of the land and any improvements and subtracting the amount of any depreciation. Sounds simple, right?

Determining Land Value Using the Cost Approach

The cost approach method assumes that property is being used for its most productive use. To do this, assume the land is vacant, and establish a value using the sales comparison approach for only the land. The land itself does not depreciate in value.

Determining Building Value Under the Cost Approach

The building’s value is based on the current cost to build it. There are a few ways to calculate this figure:

Determine the cost per square foot of a comparable building. Multiply the cost of the subject property’s square footage by that amount; or
Calculate the replacement cost of the raw goods and installation by estimating the quantity of goods and labor needed at today’s prices; or
Estimate the cost of the entire building based on the cost of a portion of the building, including materials and labor. For example, if it cost $10,000 to build a 100-square-foot portion, a building that is 1,000 square feet will cost $100,000 to build ($100 per square foot x 1,000).

Advantages of the Cost Approach Method

This method captures value not represented in the sales comparison approach, so it is particularly helpful for a property unique to its area. This can be as simple as a house over-improved for its neighborhood or more unusual like a repurposed building—like a small schoolhouse turned into a single-family home.

The cost approach method is most commonly used by insurance companies and lenders determining the replacement value of a property.

Disadvantages of the Cost Approach Method

In addition to not considering income potential, the cost approach can be challenging to apply in highly developed areas lacking comparable vacant land sales. When no vacant land has recently been sold in the area, the person creating the valuation is left to estimate the value of the land.

This past year highlights the other significant weakness of the method: the cost of materials and labors can change quickly and drastically, making the valuation quickly outdated or inaccurate. Real estate investors have felt the impact of lumber and labor shortages in the form of higher prices for months. Five years from now, a valuation of a building constructed during this period of higher-than-usual prices may reflect a value much lower than what was actually spent.

Choosing a Method

Even though there are many valuation methods for real estate, you may still encounter a property for which no method is a perfect fit. Similarly, multiple methods can seem applicable and yield different results.

Remember, a complete appraisal at minimum considers whether multiple methods are applicable. If they are, the appraiser averages them together or otherwise creates a final valuation that combines the results of the multiple methods.

Conclusion

Familiarity with real estate valuation methods is one of the most important tools a real estate investor can have. It saves time by whittling down the pool of investment opportunities and gives a mathematical way to compare the properties. Most importantly, the property’s value is the cornerstone for evaluating the potential risk and reward for investment.