The very first thing for an real estate investor to do when a potential deal is presented is to run an independent valuation, also referred to as “underwriting the deal”. There are three standard approaches to valuing a piece of investment real estate: comparable sales approach, replacement cost approach, and income approach.
- Comparable Sales. This is the easiest way to determine a properties market value is to search for and review recent sales of very similar properties, ie. “Comps” or Comparables and see what they sold for. While professional Realtors have access to the multiple listing service or MLS to search for recent sales in the target area, consumers are limited to sites like Zillow, Realtor.com and Loop.net. When searching for comparables, you want to look for properties that as are close to, and as similar to your target property as possible, and preferable those that have sold within the past six months (though appraisers can go back as far as 12 if there are a sufficient number of sales within this time period). Note the prices of recently closed transactions, including the purchase price per sq. ft, per acre, per room, and so on. The comparables should be of similar style, ie you should not compare a ranch style home to a 2-story or a split level. It’s worth noting that assessing the value of a property is not as straight forward as simply multiply the average price per sq. ft. by your target property’s sq. ft., acreage, number of rooms.
- Replacement Cost. This is another easy way to value property. Determine the cost per sq. ft. to build in your area by calling local builders and contractors, and the price per acre to purchase raw land (use the comparable sales method above). Multiply your target property’s square footage by the price to build and add the land value. That is the replacement value for your property. Your insurance company uses this method to determine your home value and if you have a good relationship with your agent you might be able to use them to double check your answer. The replacement cost is typically reserved for newly built homes as opposed to older existing homes, which tend to make up the bulk of investment properties and thus this approach is not commonly used by investors but it does allow you to determine where values are likely headed.
- Income approach. When purchasing a real estate for the purposes of cash flow, the income approach is the appropriate method to value the asset (and the income stream it produces). This is by far the best method and the most complicated but I urge you to stay with me.
CAP RATE – Each asset class (apartments, industrial land, single family homes, mobile home parks, self-storage) has it’s own range as far as a Cap Rate is concerned. The Cap Rate, also referred to the Capitalization Rate is the percentage of the purchase price that the investor would like returned to them each year. This return comes in form of the Net Operating Income. Cap Rates differ across asset classes based on a number of factors, primarily risk and intensity of management. The higher the risk, the greater the return an investor is going to require for their money. For example. hotels are perceived as being more risky than apartment buildings, so investors demand a higher return from a hotel investment and thus, a higher Cap Rate.
Cap Rate (Percent Return) X Purchase Price = Net Operating Income
Purchase Price = Net Operating Income / Cap Rate
Cap Rate is measured as a percentage, the annual return on investment. Note: The Cap Rate does not take into account your bank loan. Your return on investment will change depending on your financing methods. If you purchase a property for $100,000 that has a NOI of $10,000 per year, you would call that a 10% cap rate (also known as a 10 Cap).
To determine the standard Cap Rate for your asset class call a local real estate broker specializing in investment properties and ask him/her what the Cap Rates are in your area for residential properties (single family homes, condos and town homes), multi-family properties (duplexes, quads, apartments), industrial land, motels, or whatever type of asset you are valuing.
Now you have the Cap Rate and one crucial element of the equation, you’ll need to determine the assets Net Operating Income or NOI. Once you determine the NOI you can then calculate the maximum purchase price that you can pay for the property. NEVER rely on the numbers that the seller gives you for NOI. They will pad their income and reduce their expenses to make the property look better.
The best way to determine NOI is to start with Gross Income. What is the property making each month in revenue? You should be able to find this number. Make sure that this number makes sense. Make sure that you end up with an annual number, and not the monthly number or year to date number.
Now determine the standard expense ratio for the asset class. The expense ratio is a percentage of Gross Income that you can reasonably expect to pay in insurance, management, utilities, taxes, accounting, advertising, and so on. This number changes for each asset class but should be somewhere between 30-60% (I know that’s a big range).
Gross Income – (Gross Income X Expense Ratio) = Net Operating Income
Or, more simply
Gross Income X (1 – Expense Ratio) = Net Operating Income
Take the Gross Income and multiply it by the Expense Ratio. This number represents your estimated annual expenses. Subtract the estimated expenses from the Gross Income to arrive at your Net Operating Income. Divide the NOI by your Cap Rate and there is the valuation! That’s how you find the maximum purchase price you should pay using the income approach.
These are very simple formulas yet it is hard for many people to grasp the Cap Rate. Assuming a stable NOI, the higher the Cap Rate, the lower the purchase price. The higher the Cap Rate, the higher the perceived risk.
Parting Thoughts: Real estate agents and Local Knowledge. The easiest way to make money in real estate is to purchase a property for less than the market value. This is especially important if you won’t be adding value through “improvements and sweat equity”, and with asset classes other than residential properties which you will be marketable to investors who when it comes time to sell will be purchasing the property based off on the numbers, rather than the emotion that tends to go into a residential purchase. This is what we attempt to do in every deal, for every client.
On a separate but related note, keep in mind that values of fixed assets should be related to incomes in that area. Income is the anchor the truly determines the limits for valuation. The average family can afford a home some 2.6 to 4 times their household annual income (this varies based on the mortgage interest rates, local taxes, etc). In 2005-2006 new homes on average were selling for well over 5 times the median income! Ohio’s median income is $46,829 (this varies between counties and cities, for example, while the median home price is $195,000, putting the average home at 4.16 times the states median income.
The markets which have seen the highest returns in 2018 (change from 2017) include:
Grandview Heights – 13.4%
German Village – 11.1%
Dublin – 8.8%
Olentangy LSD (includes sections of Delaware and Lewis Center) – 6.1%
Upper Arlington – 5.5%
Powell – 4.9%
The Opland Group Specializes in Real Estate Sales, Luxury Home Sales, Short Sales in; Bexley 43209 Columbus 43201 43206 43214 43215 Delaware 43015 Dublin 43016 43017 Gahanna 43219 43230 Grandview Heights 43212 Hilliard 43026 Lewis Center 43035 Marysville 43040 43041 New Albany 43054 Pickerington 43147 Powell 43065 Upper Arlington 43220 43221 Westerville 43081 43082 Worthington 43235