Property Valuation: Why It Matters and How to Determine It
When considering a real estate investment, one of the most important factors to determine is the true value of your property.
To be clear, this is not the price that you pay for your property. Property value, according to Investopedia, is the present worth of future benefits arising from the ownership of the property. Price, on the other hand, is influenced by the seller’s motivations, the underlying condition of the home, and the immediate state of the market.
So although you may have found a distressed buyer who was willing to sell you a property for $100,000 - its value could be closer to $150,000. Big difference. And if you’re going to repair the property, there’s a chance it could be worth as much as $200,000.
Let’s dive into why real estate investors should be concerned with property valuations, and then look at how to determine them.
Why Do Property Valuations Matter?
The first time a property valuation comes into play for a real estate investor is when you’re purchasing a property and planning on improving it - either as a fix and flip or to keep as a long term rental. In that case, you’ll likely be seeking a property loan for the ARV, or After-Repair Value. Because of this, property valuation is critical for obtaining a private real estate loan.
In fact, the “70% Rule” has typically been the standard in the house flipping industry. While it’s not truly an exact rule, many industry insiders suggest that you can protect your profit margins if you spend no more than 70% of its ARV in both the purchase and repair costs.
Accurate property valuations can keep you from buying a property at too high a price - especially in a seller’s market. It can also keep you from over-renovating a property beyond its potential worth in the future.
The value of your property also influences what you pay in property taxes, as well as how much property insurance you should get. For instance, let’s say you insured the house mentioned above that was purchased for $100,000 for that price, but it was actually worth $200,000 after repairs. In the case of a total loss, the insurance company would only pay out $100,000 - which would not replace your property.
How To Value a Property
When determining the value of a property, it’s important to recognize that there are various valuation methods available.
In the three following cases, you will notice that doing due diligence and having accurate data (both on the property you’re considering and on external factors) will help you make the most correct valuation. Do not underestimate this step.
1. The Sales Comparison Approach
Also known as a Comparative Market Analysis or CMA, this approach uses “comps”, or comparable sales. These are similar properties that have recently sold in the same neighborhood.
While location is the most important factor, other factors to consider include similar size or square footage, number of rooms, age, condition and the quality of any renovation work done to the property.
After gathering data on three to five of these properties, you can find an average price between them all that could be applied to your property. You should make adjustments up or down based on how your property compares to the comps.
For instance, if your property will have renovation work completed that the comparable properties do not, such as a newly remodeled kitchen or a finished basement, then you would raise your property value slightly higher to account for that.
2. The Income Approach
While the Comparative Market Analysis typically works best for single family homes, a property with the sole purpose of generating income is often valued differently. This is often the case for properties such as commercial real estate or apartment buildings.
To do this, you need to first calculate the net operating income of the property in question, which is simply taking the revenue and subtracting the expenses. Then, divide that by the capitalization rate, which calculates your returns on the property over time.
3. The Cost Approach
For those times when you’re dealing with a truly unique property such as a school, hospital or church, the cost approach method of property valuation can be helpful. There are usually little to no comps in the area, and they have unique characteristics that are hard to duplicate.
To value a property like this, it is best to calculate the cost of replacing it completely. Something that should be considered in this case is depreciation.
Lean On Reliable Partners
Calculating property value can influence many aspects of your investment, so it’s a critical step that you want to get right. To ensure you’re taking all appropriate factors into consideration, it’s best to lean on trusted professionals so that you have a variety of informed perspectives.
Your private lender can help advise you on how to most accurately and effectively determine the value of a property today and in the future. If you’re looking for guidance on how to take the next steps for your upcoming real estate investment, connect with an advisor at Temple View Capital today. As a hard money lender for non-owner-occupied investment properties, they are experienced at working with real estate investors who rely on accurate property valuations to minimize risk and maximize returns.