How To Unlock Hidden Value In Real Estate

Understanding how to calculate market value in different scenarios can help you find hidden value in rental properties.

Aug 17, 2014 at 8:45AM

The market value of a property is the amount of money that a buyer is willing to pay and a seller is willing to accept. When you make an offer to buy a home and the seller agrees to your offer, you are in essence establishing the market value of that property.

That definition seems straightforward enough, right? 
But what if another buyer was willing to pay more, but they haven't yet come across the property for sale? Or what if the seller was behind on his mortgage payment and is facing extreme pressure to sell quickly? Or what if you intended to use the property as a rental instead of as a place for your family to live?

Couldn't all these varying conditions effectively change the "market value" of your property?

The definition of market value

House Dice Chopped Money Flickr Httptaxrebateorguk
Source: Images Money

The Appraisal Institute, the governing body of appraisers in the U.S. defines market value very precisely. Instead of the simplistic definition previously mentioned, the Appraisal Institute includes several parameters to clarify the market value in a given situation.

This next section is a bit technical, but the significance is huge. So bear with me, if you will (and I promise to keep it short).

True market value assumes that:

  • Buyer and seller are typically motivated; 

That is, neither is under undo pressure to buy or sell, like in the pending foreclosure example above.

  • Both parties are well informed and well advised, and acting in what they consider their best interests;

Only third party transactions apply -- buyer and seller are both maximizing their own interests.

  • A reasonable time is allowed for exposure in the open market;

So that all potential buyers have the opportunity to make an offer, and the seller has ample time to assess demand.

  • Payment is made in cash in U.S. dollars or in terms of financial arrangements comparable thereto; the price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale;

This last example is a biggie. This long-winded assumption basically means that the transaction is done with either cash or a typical mortgage loan. Any other crazy arrangements -- a 100 year mortgage loan or a loan with negative interest rates, as examples -- would not be viable in a determination of real market value.

How this applies to your real estate investing
The biggest takeaway is that market value is not as straightforward as it first seems. The most critical nuance is the intentions of the buyer and the seller. It is in these details where smart investors can find hidden value.

When a seller is facing foreclosure, they are highly motivated to sell. They will oftentimes accept a price lower than market value just to avoid the foreclosure. The same is true of a bank after the foreclosure -- the bank does not want to own the real estate, it simply wants to recoup its principal investment.

This creates a great opportunity to buy an asset at a price that is lower than what it's really worth.

It can also improve your results when selling real estate

House On Scale Flickr

Source: Images Money

The same nuance can also raise the value of your property when the time comes to sell. For example, perhaps the rental market in your area is particularly hot. An investor may be willing to pay you more for your home than an owner occupant would. It doesn't matter if you live in this particular property or if it's a rental -- the "market value" would be higher by selling to the investor instead of the owner occupant.

Or perhaps your home is in an older neighborhood that is undergoing a major renovation with new developments. A developer may be willing to pay a whole lot more for your property (and possibly your neighbors as well in a package deal), than either a rental investor or owner occupant. The developer would take the land and redeploy it as apartments or some other new construction. If the upside potential is high enough, your property could be worth multiples more to a developer than to a family.

The key is to understand the intended purpose of the property at its highest and best use. Highest and best in this case are used in strictly financial terms. Understand the other persons perspective and give the open market time to work its magic. 

Use your new understanding of the technical definition of market value can unlock new potential to find hidden value as a buyer and unlock hidden equity as seller.

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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