Real Estate Valuation Methods: A Comprehensive Guide
Determining the investment value of a property is an art that requires different methods. Unlike valuing a house that you intend to live in, a property’s investment value involves various real estate valuation techniques. In this article, we will explore several methods and discuss their advantages and disadvantages, knowing that there is no right or wrong system. Successful real estate professionals should understand all the systems to communicate effectively with their clients. A rental property’s value depends on its income, expenses, and financing, making it essential to consider all three parts when valuing it. We will discuss five real estate valuation methods used in the market for investment and their pros and cons.
Valuation methods
Price per square foot
The initial method of valuation is called “price per square foot.” To calculate the price per square foot, you divide the cost of the property by the number of square feet. For instance, if a 6-unit apartment building costs $390,000 and has 3,000 square feet, the price per square foot would be $130.00.
However, the price per square foot method alone is insufficient to determine if a money machine costing $130.00 per square foot would be a wise investment. This method disregards crucial factors such as income, expenses, and financing. While comparing the price per square foot of various properties can provide some insight, it does not provide enough information to make an informed investment decision.
Price per unit
To calculate the price per unit, you need to divide the total cost of the property by the number of units, usually apartments. For instance, if the property cost is $390,000 and there are 6 units, the price per unit will be $65,000. However, it’s important to note that this formula only considers the property’s cost and doesn’t take into account other factors like income, expenses, or financing. Therefore, while it can give you an idea, it’s not a very meaningful way to evaluate a property.
Gross multiplier
The third technique used for property valuation is known as the “gross multiplier” method. This method involves dividing the property’s cost by its gross operating income. For example, if the gross operating income for a 6-unit property is $56,715 and its cost is $390,000, the gross multiplier formula would be $390,000 / $56,715, resulting in a value of 6.88. While this method considers income, it does not include expenses or financing.
Capitalization rate
The term “capitalization rate” or “cap rate” is frequently heard in the real estate market. It is expressed as a percentage and is calculated by dividing the net operating income by the cost. For instance, the net operating income for a 6-unit property is $30,065, which when divided by the cost of $390,000, results in a cap rate of 7.7%. This means that the property generates 7.7% of its cost in net operating income.
Cap rates can be beneficial when comparing different properties since they help determine which one produces the highest percentage of net operating income. Capitalization rates consider both income and expenses since they are calculated using the net operating income. However, they do not take into account financing, as cap rates are based on the assumption that you pay cash and do not account for debt service payments.
Cash on cash
The “cash on cash” measure is used to determine the amount of cash flow an investor can earn based on the cash they have invested. The formula for this measure is the cash flow before taxes divided by the cash invested. This approach emphasizes the importance of cash flow as the primary financial benefit of owning investment real estate. While other benefits such as principal reduction, tax savings. Appreciation are also valuable, cash flow is considered as the most crucial. In the past, investors were willing to purchase properties with negative cash-on-cash returns, as they relied on tax benefits and appreciation to compensate for the negative cash flow.
Which valuation method is the strongest?
The “cash on cash” method is the most robust among the various property valuation techniques we have discussed. It takes into consideration the three fundamental aspects of rental property income: revenue, expenses, and financing. This method enables you to compare different properties in a standardized way. Experienced investors usually have a specific cash-on-cash rate that they aim for. They only buy properties that meet or exceed their target rate; otherwise, they pass on the opportunity.
Remember, there’s no one-size-fits-all approach to property valuation. Regardless of the method you use, it’s crucial to reassess the value of your investment property each year.
