How do you calculate a property's investment value? It's an art, I guess. It's not the same as valuing the home you intend to live in. That is something a homeowner would value. There are several different real estate valuation techniques you can employ when determining a property's investment worth. We'll go over a number of strategies in this article and talk about their benefits and drawbacks.
Remember that there is no right or wrong approach to appraisal. Successful real estate agents should be familiar with each system in order to interact effectively with a wide range of buyers and sellers in a wide range of circumstances.
An investment property in real estate is similar to a money maker. The three essential components are funding, costs, and income. How these three components work together determines the worth of the money machine. Therefore, wouldn't it make sense that the best method of pricing a rental property would take into account all three components? In light of this, let's examine five common valuation techniques and weigh their advantages and disadvantages.
Valuing Techniques
Per Square Foot Cost
The first technique of appraisal is "price per square foot." The cost of the property is divided by the square footage to determine the price per square foot. Consider a 3,000-square-foot, six-unit apartment building that costs $390,000. $130.00 per square foot is equal to $390,000 divided by 3,000.
Would an investment in a money machine that costs $130.00 per square foot be wise? Without knowing the revenue, costs, and financing—which the price per square foot approach ignores—there is no way to know. Perhaps the only benefit of this approach is that it allows you to "test the wind" by comparing the price per square foot of several properties. Even yet, you lack the knowledge necessary to choose an investment wisely.
Cost Per Unit
The cost of the property is divided by the number of units (usually apartments) to determine the "price per unit." In our example, the cost of $390,000 would be divided by 6 units, resulting in a unit price of $65,000.
The price per unit is equivalent to everything we said about the price per square foot. Income, costs, or financing are not taken into account. Again, it may be a tool to gauge the wind, but its significance is minimal.
Total Multiplier
The third technique is known as the "gross multiplier." The cost of the property divided by gross operational income is the formula. Let's assume that $56,715 is the gross operating income for our six-unit scenario. Our gross multiplier is calculated by dividing our cost of $390,000 by our gross operating income of $56,715. It comes out to 6.88.
The gross multiplier approach, in contrast to the first two, does consider income. What about the money maker's other two components, financing and expenses? Both of these are not taken into consideration.
Rate Of Capitalization
The term "capitalization rate" (sometimes known as "cap rate") is one that you frequently hear in the business world. A percentage is used to represent it. The net operating income divided by the cost is the capitalization rate calculation formula. The net operating profit for the six units is $30,065. 7.7% is obtained by dividing $30,065 by $390,000. That is a cap rate of 7.7%. What does that signify, though?
This property is generating net operating income equivalent to 7.7% of its cost, which is one way to look at the cap rate. Cap rates can therefore be useful when contrasting two or more properties. You can determine which property is generating the largest percentage of net operating income once you know the cap rates of each.
Does the capitalization rate consider income? Yes. Expenses? Because we're utilizing net operating income, the answer is yes. The funding is not taken into account by the cap rate, which is a crucial distinction. The cap rate is based on net operating income, which is what we have left over after paying debt service, which is why. The cap rate presupposes cash payment.
Money On Money
"Cash on cash" measures the amount of cash flow an investor would receive in relation to the money they invest. Cash flow before taxes is divided by capital invested in the calculation.
This approach emphasizes cash flow as the most significant financial advantage of owning an investment property. Although the other three advantages (principal reduction, tax savings, and appreciation) are excellent, the main focus here is on cash flow. In actuality, having cash on hand is more crucial than ever. In the past, investors might occasionally agree to purchase real estate with a negative cash-on-cash return if they thought the tax advantages or the appreciation would make up for the low cash flow. However, the tax advantages have already been diminished, and appreciation is no longer a given. Today, a property often needs to generate a sizable cash-on-cash return in order to be profitable.
Which Valuation Technique Is The Most Reliable?
Of the valuation techniques we've studied so far, "cash on cash" is the most reliable. It considers the money machine's three components—income, expenses, and financing. You may compare properties on an apples-to-apples basis when you pay cash on cash. A "target" cash-on-cash rate is something that many seasoned investors have. If the property will generate cash on cash at or above their target rate, they will purchase it. In that case, they leave.
Learn about a sixth valuation technique in Real Estate Investing: Beyond the Basics, an even more potent technique that enables you to determine the desired rate of return and then work backward to determine the ideal price of a rental property.