- September 2, 2020
- Posted by: Editor
- Category: Advice
The value of a property is the most important feature when renting a home.
In real estate investing, property valuation is a key concept. Not knowing the value of an investment property makes it difficult to know the amount of rent to charge for it 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.
Having known the importance of property valuation, it’s time to discuss the three main property valuation methods:
The first method of valuation of a property 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 replica of the property in context. 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, 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
Income Capitalization Approach
This method, unlike the cost approach, 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
- Gross income multipliers.
Direct capitalization focuses on a property’s income. The property’s annual gross income is estimated. The effective gross income is then estimated by considering the impact of vacancies. Then, the net operating income is gotten after subtracting expenses. The property’s value is then estimated using the property’s capitalization rate, or cap rate, and net operating income.
Gross income multipliers are used for real estate properties that are not initially purchased as income properties but end up being used as such. Examples include family homes. Here, 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 gives the gross income multiplier, which is then used to find the property’s market value.
Sales Comparison Approach
Sales comparison approach is the most popular of the three property valuation methods. 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. The properties used for comparison are called comparables. Properties are only considered comparables if they are related or very similar to the property and have been sold within the year under ordinary market conditions.
In order 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.
Factors that influence the rental property’s market value include:
- Physical aspects of the property.
- The age of the property.
- Market conditions during the purchase.
The most important of these factors is 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 land mass, 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.
Knowing the valuation methods for your property is essential for real estate appraisal. Although 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 an idea.