Let’s get philosophical for a minute. How do you put a value on anything? Okay, maybe we don’t need to have a philosophical discussion. At the same time, putting a value on things can be difficult, especially real estate.
Real estate value is based on many things. At the same time, the value must be rooted in reality. Whenever you buy or sell anything, you should always know its value. But don’t get confused—the price of real estate doesn’t necessarily equal its value.
In fact, price, cost, and value aren’t synonyms. A property’s cost relates to expenses like materials and labor used to build the property. Price is what someone pays for a property (a.k.a. the selling price), which may or may not reflect the property’s cost or value.
In contrast to both price and cost, at Trion Properties, we base value on a property’s benefits to the owner over time. In other words, a property is worth what someone else will pay to own that asset. Over time, values fluctuate.
Related: How to Become a Real Estate Investor
Why is it Important to Value Your Property?
Accurately valuing your property is crucial to selling it for an appropriate price. Overall, there are two major mistakes that owners make when valuing your property:
- Valuing the property too high – If you value a property on the high end, you may have fewer interested buyers. As a result, it might take longer to sell a property that you’re ready to off-load.
- Valuing the property too low – On the other end of the spectrum, a property that’s valued too low might attract buyers who try to low-ball you for an already low-priced property. Undoubtedly, every investor dreams of finding a great bargain on real estate. However, you don’t want your property to be that amazing deal.
As an owner, you want a buyer to pay a healthy, reasonable price for your asset so, you must price it appropriately by basing the selling price on a property’s value. But how do you value your property? Below are some property valuation strategies.
Different Property Valuation Strategies
How do you actually value your property? If you want to sell an apartment building, how do you decide how much it’s worth? Or if you own an office building, how would you find out an appropriate selling price?
When a real estate appraiser looks at your property, they look at a number of factors. Some of these factors are unique to the asset class. Other factors, like location, nearby amenities, proximity to major transportation arteries, etc., are not directly related to the property. To help you understand how an appraiser values your property, here are several common valuation methods.
Income Approach
This valuation approach focuses on the property’s potential rental income. It looks specifically at the amount of net income it will create for the next owner. This approach is very useful for properties with tenants like office buildings, retail centers, warehouses, and apartment buildings. The income approach is also helpful for properties with relatively predictable expenses. A quick calculation is:
NOI (Net Operating Income) / Cap Rate = Current Property Value
In this formula, the income approach links value to rental income. In brief, the NOI is income (annual) while the cap rate (capitalization rate) is the return that a property might generate. For example, if your property has a $500,000 NOI and a 9% cap rate, then:
$500,000 / 9% (0.09) = $5,555,555
According to the income approach, the property value is $5.5 million.
Related: How to Value Real Estate
Cost Approach
This valuation approach looks at the cost to replace the property plus the land it sits on. The estimated replacement cost factors in materials, labor, land, and other things to determine property values. In addition, depreciation (anything that lowers property values) is a factor big in the cost approach. It covers things like outdated features, structural issues, aging systems, and deterioration due to the property’s age.
An appraiser might use the Square-foot method (compares cost per square feet), the Unit-in-place method (estimates construction cost), or the Quantity-survey method (estimates price of raw materials along with the cost to totally replace the property). Basically, this approach assumes that a buyer doesn’t want to pay more for an existing property than they would to build the property from the ground-up.
The cost approach is useful for appraising significantly improved properties. It also works well for valuing properties that aren’t sold often, for non-income producing properties, or older properties. However, one weakness of the cost approach relative to older properties is that it doesn’t always consider ongoing maintenance costs.
Market Approach
In the market approach, real estate values are relative. Specifically, appraisers value your property by looking at similar properties. You’ve probably heard the term ‘market value.’ This is the value of a property in the open market. In other words, it’s how much a buyer will pay for a property in a certain market at a certain point in time.
If you’ve ever bought or sold a house, then you’ve seen the market approach in action. Your real estate agent uses comparable properties (or comps) to show you approximately how to price a home you’re selling (or how much you should pay for a residential property).
In the market approach, the appraiser values commercial property in relation to comps’ recent selling prices. By reviewing recent sales of similar commercial properties and then adjusting for factors like amenities, location, and square footage, they arrive at a value. If you’re selling a medical office, they present you with selling prices and values of other medical offices by way of comparison.
This approach works best when there are enough similar properties and sufficient data from those properties. On the contrary, not having enough comps makes the market approach more difficult.
GRM (Gross Rent Multiplier)
GRM is similar to the Income Approach. Yet, instead of NOI, it uses gross rents. Overall, the GRM approach is a quick, ‘back of the envelope valuation. Here’s the formula:
Annual Gross Rents x Gross Rent Multiplier = Current Property Value
For this approach, your concern is how much rent the landlord would get annually—the gross rent. As the name implies, this is a comprehensive number that doesn’t cover expenses like insurance, utilities, and property taxes.
This simple method works well if you have accurate GRM estimates of comps. But how to find GRMs? An appraiser or commercial real estate agent can help you find the GRM of local comps. Once you know the GRMs of a few comps, you then use them to value your own property. For example, if a comp recently sold for $350,000 and produces $65,000 in annual gross rents, you divide the sale price by the rental income for a GRM of 5.38:
$350,000 / $65,000 = 5.38
You then multiply the comp’s GRM by the gross rents of your property to calculate the current property value. Although this approach is simple, one of the drawbacks to that it doesn’t factor in expenses.
How does Residential and Commercial Property Valuation Differ?
Commercial properties are very different from residential properties. The main differences stem from their function. In other words, how are they used? Commercial properties hold businesses like restaurants, shipping companies, manufacturers, medical offices, self-storage facilities, and many other types of businesses. Residential properties house people. Apart from these obvious superficial issues, valuing residential properties and commercial properties differ in a number of ways.
One of the biggest differences between residential and commercial property values is revenue. Although residential properties generate revenue through tenant rents, commercial real estate has other ways of generating revenue for owners. For example, retail property owners often get a percentage of their tenants’ retail sales. That said, apartment buildings with more than 4 units are considered to be commercial real estate and so here the lines between ‘commercial’ and ‘residential’ can get somewhat blurred.
When we talk about the value of residential real estate, we’re specifically dealing with the property’s market value. What will a buyer pay for a similar property in a similar neighborhood in a certain town or city? This is an estimate of your property’s sale price based on a professional appraisal.
Another big factor in determining commercial property values versus residential property values is the economy. Since commercial properties usually house businesses, the success of these businesses directly impacts the property owners. If a commercial tenant suffers during an economic downturn, your property could lose tenants or a landlord may choose to lower rents to retain tenants. Either way, property revenue declines. Apartment buildings aren’t so sensitive to the same economic factors because as the economy contracts, people still need a place to live making multifamily a more stable asset class.
As you can see, the value of residential property is tied more closely to the local real estate market than non-apartment commercial properties. Because of this, a residential property’s selling price hinges more on nearby comps and recent sales. Of course, there are other factors (age, condition, location, etc.), but overall, the market dictates the value and by extension the selling price, so the value of a residential property will rarely be more than the local comps.
How to Value Commercial Real Estate
The person who buys your commercial property, including apartment buildings, is more concerned about the return on their investment rather than their enjoyment of the asset so they typically want to know more about the asset than just the selling price. In this business-focused sector, commercial real estate values are based on many more factors than smaller scale residential real estate valuations so in contrast to residential properties, commercial real estate valuation hinges greatly on a property’s income-generating potential for the next owner.
Keeping in mind the valuation approaches above, understand commercial property valuation requires a much more detailed approach than residential real estate. Typically, the more complex the property, the more complex the appraisal. Yet regardless of the asset class, property size, or other factors, commercial property values are closely related to their capacity to create income for the owner. As stated above, to properly calculate your commercial property’s value, you need to know details like the NOI (net operating income), cap rates, and cash on cash return.
As a reminder, NOI is your property’s income after you pay expenses, but before you cover the debt (or the mortgage). Also, the cap rate is the return the buyer would get if they paid cash for your property i.e. with no leverage. You can find the cap rate by looking at sales of similar properties. If you know the NOI of another deal, you divide it by the sales price to learn the cap rate:
NOI / Sale Price = Cap Rate
On top of that, potential buyers want to see an income projection. One way of projecting your property’s income is with a real estate pro forma. However, a pro forma is much more than a simple report. Often, a pro forma includes multiple lines of details that break down various expenses and income streams. This projection gives the buyer a realistic idea of their income over a certain period of time (5 years, 10 years, etc.) to help them determine the quality of the investment.
How to Value Residential Real Estate
As mentioned above, residential properties include single-family homes, duplexes, triplexes, and even fourplexes. In general, valuing residential properties involves fewer factors. Compared to commercial real estate valuation, finding the value of residential real estate is far less complex. If you own a rental house or a condo, your best resource for valuing a residential property is a local real estate agent. An agent will help you find all types of details that affect the property’s value, such as:
- Recent comparable sales for nearby residential properties
- Historical sales data on the property you’re selling
- Physical characteristics like location, lot size, number of bedrooms and bathrooms
- Neighborhood information and nearby amenities
- Local school district information
- Property tax details
Having these and other details give you a more detailed picture of a residential property’s value. Yet, as tempting as it might be to take Zillow’s word for a residential property’s value, the typical consumer-facing online tool can give inaccurate pricing. For wise investors who want to sell their residential investments, the best way to find the property’s value is by connecting with a real estate agent.
You might think that you can find all the information you need on your own. Maybe to a certain extent, that’s true. However, agents have access to MLS data (Multiple Listing Service). By using the MLS, they can provide you many more details on your property as well as details on local comps than you could ever get yourself. What’s more, the agent can set up MLS searches for comps which give them accurate data that Zillow never could.
On top of that, an agent often does a comparative market analysis (CMA). A CMA looks at homes of a similar size, type, age, style, lot size, and other factors. Also, this report goes beyond what’s on the market now and looks at historical data. For instance, the agent might show selling prices for nearby comps for the past six months to give you an accurate valuation.
Conclusion
Whether you’re buying or selling a property, the sale price will always be relative to its value. Since real estate is such a large asset with such a high price tag, you need to be sure that your property is valued properly. You don’t want to ‘lose your shirt’ on a sale, but you also want to get your property sold so you don’t hold it forever. If anything, you want the sale to put more money in your wallet than less. By understanding valuation and using one of the preceding methods, you can find an appropriate value for your property and sell it for the highest price and best terms. Check out our portfolio of multi-family investments at Trion Properties.