Valuation methods for investment in real estate
Investment properties are valued differently than residential real estate because they are income producing. The amount of cash flow an investment property earns or has the potential to earn carries more weight than the cost value of the property, which includes the land, building, or assessed value. Even a formal real estate appraisal will take the income an investment property produces into consideration on the appraisal.
When used as an investment property, residential property, including a single-family home, duplex, triplex, or fourplex, will typically use an income value approach to determine its value. Income approach or gross rent multiplier is the number of times an investor would be paying for a property in relation to its rent. Valuing a property with an income approach helps buyers determine whether an asset is a worthwhile investment in relation to its fair market value.
Many times a residential property can be valued more than the property's income supports. For example, if a property is assessed or appraised at $300,000, it should earn around $3,000 in monthly rental income to justify the fair market value using the 1% rule, and in essence, make sense from an investment perspective. However, if the property only brings in $1,500 a month, it's unlikely the fair market will be warranted as an investment property.
Commercial properties are typically valued with an income approach called a capitalization rate, or cap rate for short. The cap rate of a property is the net operating income (NOI), or all income after expenses but before debt service divided by the purchase or sale price.
For example, if a commercial property such as an apartment complex, has an NOI of $62,000 and the asking price for the property is $1,100,000, the cap rate would be 5.6% ($62,000/$1,100,000). The lower the cap rate, the more the buyer is willing to pay for the income it produces and the lower the return they receive.
In another example, if an industrial building produces an NOI of $120,000 but the asking price for the property is only $975,000, the cap rate would be 12.3%. The higher the cap rate, the less the investor is paying in relation to the income it produces and the better return they will earn.
Both of these methods ultimately help the investor determine the value of the property and their return on investment if they were to purchase the property at said value.
Importance of commercial property valuation
If an investor is buying a commercial property and obtaining a loan, the bank or lender will request a formal appraisal. The appraisal should use both cost value and income approach to determine the true value.
These appraisals are typically fairly accurate, but there are times, like when a property is underperforming and the investor expects to increase the value, where the current value or appraised value is not an accurate reflection of the property's value. In that case, the investor wants to use a future value or a pro forma analysis of the property to determine the potential value of the property after it's been improved. This takes into account the future cash flow, operating income, operating expenses, and like sales price based on market defined capitalization rates.
Property valuation in summary
If you are looking for a property valuation, determine what type of valuation is needed for the specific real estate. This will help you determine what type of real estate advisory is needed, like a formal appraisal from a licensed appraiser, a Realtor's opinion of value, or a potential future value, pro forma projection. Investors typically use multiple valuation methods to determine the ideal purchase price or sales price to accomplish their ideal yield or return on investment.