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Real estate valuation can be complex. Whether you're trying to understand what your home is worth or how to value investment property, it's important to understand how real estate valuation works and how it can differ depending on the property type or property use.
This article explains how to value real estate, including common real estate valuation methods.
What you should know about real estate valuation
Valuing real estate can be difficult because almost no two properties are the same. Each has unique characteristics with different square footage, number of bedrooms or bathrooms, upgrades or features, cash flow, rentable units, net operating income, or location.
The real estate market is one of the largest determinants in the real estate valuation process. It's the reason a single-family home in Ohio can be hundreds of thousands of dollars less than a nearly identical property in the Bay Area. The real estate market matters. Markets with a high supply and low demand will have lower values compared to areas with high demand and low supply.
Experienced real estate professionals will become experts in their local real estate market, getting to know what various property types sell for, such as commercial real estate versus residential real estate, by consistently staying in touch with what properties are being listed and sold for.
The most widely accepted method for valuing property is a real estate appraisal, which is used in both commercial real estate and residential real estate and can only be conducted by a licensed appraiser. Real estate professionals, such as real estate agents and certain inspectors, are able to provide other, less formal methods of estimating a property's value, including a comparative market analysis (CMA) or broker's price opinion (BPO).
Property valuations are used to determine:
- Assessed value, which is used for tax purposes.
- Fair market value, which is the as-is value of the property in the current market and can be used for sales purposes.
- Actual or replacement cost value, which is how much a property would cost to replace or the actual cost to build the property, typically used for insurance purposes.
- Potential future value, which is most frequently used with real estate investments such as commercial real estate or fix-and-flips.
Investors and real estate professionals can change the valuation method depending on what value they are trying to obtain.
Valuation methods for residential real estate
Most residential real estate, with some exceptions for real estate investments, is valued by using comparable properties, or comps. That means the Realtor, appraiser, or other individual attempting to value the property will search for similar properties that recently sold or are pending sale or for sale that are the most like the subject property based on the following features:
- Property type.
- Number of bedrooms and bathrooms.
- Size/square footage.
- Age of home/year built.
- Condition, features, or upgrades.
- Style of property (such as two-story, ranch, Spanish, etc.).
Valuation methods for investment in real estate
Investment properties are valued differently than residential real estate because they are income producing. The amount of cash flow an investment property earns or has the potential to earn carries more weight than the cost value of the property, which includes the land, building, or assessed value. Even a formal real estate appraisal will take the income an investment property produces into consideration on the appraisal.
When used as an investment property, residential property, including a single-family home, duplex, triplex, or fourplex, will typically use an income value approach to determine its value. Income approach or gross rent multiplier is the number of times an investor would be paying for a property in relation to its rent. Valuing a property with an income approach helps buyers determine whether an asset is a worthwhile investment in relation to its fair market value.
Many times a residential property can be valued more than the property's income supports. For example, if a property is assessed or appraised at $300,000, it should earn around $3,000 in monthly rental income to justify the fair market value using the 1% rule, and in essence, make sense from an investment perspective. However, if the property only brings in $1,500 a month, it's unlikely the fair market will be warranted as an investment property.
Commercial properties are typically valued with an income approach called a capitalization rate, or cap rate for short. The cap rate of a property is the net operating income (NOI), or all income after expenses but before debt service divided by the purchase or sale price.
For example, if a commercial property such as an apartment complex, has an NOI of $62,000 and the asking price for the property is $1,100,000, the cap rate would be 5.6% ($62,000/$1,100,000). The lower the cap rate, the more the buyer is willing to pay for the income it produces and the lower the return they receive.
In another example, if an industrial building produces an NOI of $120,000 but the asking price for the property is only $975,000, the cap rate would be 12.3%. The higher the cap rate, the less the investor is paying in relation to the income it produces and the better return they will earn.
Both of these methods ultimately help the investor determine the value of the property and their return on investment if they were to purchase the property at said value.
Importance of commercial property valuation
If an investor is buying a commercial property and obtaining a loan, the bank or lender will request a formal appraisal. The appraisal should use both cost value and income approach to determine the true value.
These appraisals are typically fairly accurate, but there are times, like when a property is underperforming and the investor expects to increase the value, where the current value or appraised value is not an accurate reflection of the property's value. In that case, the investor wants to use a future value or a pro forma analysis of the property to determine the potential value of the property after it's been improved. This takes into account the future cash flow, operating income, operating expenses, and like sales price based on market defined capitalization rates.
Property valuation in summary
If you are looking for a property valuation, determine what type of valuation is needed for the specific real estate. This will help you determine what type of real estate advisory is needed, like a formal appraisal from a licensed appraiser, a Realtor's opinion of value, or a potential future value, pro forma projection. Investors typically use multiple valuation methods to determine the ideal purchase price or sales price to accomplish their ideal yield or return on investment.
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