Ben Le FortFollow
Jul 31, 2018·4 min read·
3 Methods To Value Real Estate
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Investing Versus Speculating
A lot of people confuse the price of real estate with the value of real estate. Price is what the buyer spends to acquire real estate, value is what the buyer receives for that price. The two are not always the same.
If you are receiving equal or greater value for the price you pay, your investing. If you the price you pay is greater than the value you receive for that price, you are speculating.
Whats the difference Between Investing & Speculating?
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With any investment, there is a chance you could lose the principle you invested. Ask anyone who bought a house right before the 2008 market crash, no investment is without risk. However, when you are investing, your decisions should be driven by the numbers. Investors will ask themselves if the rental income and total costs associated with this real estate deal support the price that is being asked.
With a good real estate investment, you should be confident that barring some unforeseen circumstances (like a market crash) you are confident your principal is secure and you are likely to make a positive return on your investment.
Speculators, on the other hand, will purchase a property not based on the income and cost numbers associated with the property but on their belief that the value of the property will increase significantly. In a way, they are betting on price appreciation. If the price does not appreciate or decreases they could end up losing some or all of their principal investment.
This is not to say, that you cant make money speculating. Lots of people have made big money from speculating on real estate. On the other hand, lots of people have lost big money from speculating on real estate.
3 Common Methods to Value Real Estate
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1. The Sales Approach
The sales comparison approach is commonly used to value single-family (e.g house or condo) real estate properties. This method values properties based on what properties with similar features in the same geographic area have sold for recently.
Lets say you were thinking about buying a particular house and you wanted to know the approximate value. The house is 1,500 square feet, has 3 bedrooms, 1 bathroom, and a single car garage. Using the sales approach you would look at what price properties that are 1,500 square feet with 3 bedrooms, 1 bathroom, and a single car garage (similar features) have recently sold for in the neighborhood (similar geography).
If you are looking at property in a residential area, often times many of the homes in the neighborhood were built by the same builder so finding nearby properties with similar features should not be difficult.
The sales approach is a helpful indicator of the current value of a single family home. If an identical home sold for $250,000 yesterday you would likely not want to pay more than $250,000 for the same home today.
2. The Cost Approach
The Cost approach is commonly used to value special use properties such as churches or libraries. The cost approach says the value of a real estate property should be equal to the cost to build an equivalent building.
If you want to know, what is the value of a church? The cost approach would answer that question with a question, how much would it cost to build a new church of the same size?
3. The Income Approach
The Income approach is commonly used to value multi-family properties such as a duplex, triplex or apartment building. The income approach says the value of a real estate property is determined by taking what is called the Net Operating Income (NOI) of the property and dividing it by the cap rate.
NOI= All revenue from a property minus all operating costs. NOI is calculated before taxes and does not include the cost of a mortgage/loan.
Cap Rate= NOI divided by the sale price of the property
Cap rates are often determined by the NOI & Market value of similar properties in the area.
Lets say you were looking at a small apartment building that had an NOI of $75,000. After doing some research you found the average cap rate for similar apartment buildings in the neighborhood was 8%.
The income approach would value the property at $937,500 ($75,000 divided by 8%).
Its important that you do ALL your research and have an accurate measure of the revenues from a building, the costs, and an accurate cap rate. If you get any of these variables incorrect your perceived value of the property could be much different than the real value of the property. These calculations should be made by a professional who knows the local real estate market well.
An Extended Discussion on the 3 Methods to Value Real Estate
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information presented will be accurate. Consult a financial professional before making any major financial decisions.