How to Value A Real Estate Property
Valuing a real estate property can help to compare investment opportunities with each other and is critical when making an investment decision. Depending on the location where the property can be found, prices can vary and this helps sellers determine the selling price of their property. A real estate valuation is typically done with three main approaches: a cost-based approach, a comparison approach, and income capitalization.
What Is Property Valuation?
Property valuation is a calculation used by real estate investors to determine the economic value of a particular property as of a specific date. Certain factors are considered when appraising a property, including the property’s square footage, acreage, amenities, renovations/improvements, location, and market conditions.
The Income Approach
The income approach is the most frequently used appraisal method for commercial real estate properties. This approach is highly favored among investors because it projects the cash-on-cash rate of return for the buyer, or in other terms, the income the property is expected to generate in the long run.
The income approach calculates the current value of a property by dividing the net income generated (NOI) by the capitalization (cap) rate, forming the following equation:
Value = NOI / Cap Rate
To approximate the net operating income (NOI), you must collect income and expense statements for the prospective property as well as for similar properties in the same area. Getting an estimate for the NOI is broken down into four steps:
- Estimate the gross potential income: This is the total income a property can generate at 100% occupancy.
- Estimate the effective gross income: This is accomplished by estimating vacancy costs based on similar real estate in the same area, which reflects the normal loss of income because of probable vacancies (essentially gross potential income minus vacancy costs).
- Estimate property expenses: These are categorized as fixed expenses (such as property taxes and insurance) and variable expenses (such as property management fees, utilities, and maintenance).
- Calculate NOI: This is calculated by subtracting the estimated property expenses from the effective gross income.
The Sales Comparison Approach
Also referred to as the “market approach,” the sales comparison approach estimates property valuation by using market data of sale prices. This method compares a property to other similar properties sold over the past year. Comparable properties, or comps, should share certain features with the prospective property in question, such as square footage, age of the building, number of rooms, and, most importantly, location. This technique is typically used for residential, though it could also be used when comparing commercial properties.
The Cost Approach
The cost approach provides a value indication that is the sum of the estimated land value, plus the depreciated cost of the building and other improvements. The total cost of constructing a new building today frequently sets the upper limit of value, assuming the building is the highest and best use for the land. When all estimates have been gathered, the cost approach is calculated in the following way:
Cost – Depreciation + Land Worth = Value of the Property
This approach is generally uncommon for residential assets and is more common for buildings like schools, churches, hospitals, government buildings, and similar types of properties.
