Learn to Value Real Estate Investment Property

 FACEBOOK
 TWITTER
 LINKEDIN

BY ARTHUR PINKASOVITCH

Updated Jun 25, 2019

From a quantitative perspective, investing in real estate is somewhat like investing in stocks. To
profit, investors must determine the value of the properties and make educated guesses about
how much profit each will make, whether through property appreciation, rental income, or both.

Equity valuation is typically conducted through two basic methodologies: absolute

value and relative value. The same is true for property assessment. Discounting future net
operating income (NOI) by the appropriate discount rate for real estate is similar to discounted
cash flow (DCF) valuations for stock; integrating the gross income multiplier model in real estate
is comparable to relative value valuations with stocks. Below, we'll take a look at how to value a
real estate property using these methods.

TUTORIAL: "First Time Homebuyer's Guide"

The Capitalization Rate

One of the most important assumptions that a real estate investor makes when valuing properties
is choosing an appropriate capitalization rate, which is the required rate of return on real
estate net of value appreciation or depreciation. Put simply, it is the rate applied to net operating
income to determine the present value of a property.

For example, if a property that is expected to generate net operating income (NOI) of $1 million
over the next ten years is discounted at a capitalization rate of 14%, the market value of the
property is $1,000,000 / .14 = $7,142,857 (net operating income/ overall capitalization rate =
market value).

The $7,142,857 market value is a good deal if the property sells at $6.5 million. It is a bad deal if
the sale price is $8 million.

Determining the capitalization rate is one of the key metrics in valuing an income-generating
property. Although it is somewhat more complicated than calculating the weighted average
cost of capital (WACC) of a firm, there are several methods that investors can use to find an
appropriate capitalization rate. (For related reading, see "4 Ways to Value a Real Estate Rental
Property")

The Build-Up Method

One common approach is the build-up method. Starting with the interest rate, add in:
 1. The appropriate liquidity premium (arises due to the illiquid nature of real estate)
2. Recapture premium (accounts for net land appreciation)
3. Risk premium (reveals the overall risk exposure of the real estate market)

Given an interest rate of 4%, a non-liquidity rate of 1.5%, a recapture premium of 1.5%. and a
rate of risk of 2.5%, the capitalization rate of an equity property is summed as: 6+1.5+1.5+2.5 =
11.5%. If net operating income is $200,000, the market value of the property is $200,000/.115 =
$1,739,130.

Obviously, performing this calculation is very straightforward. The complexity lies in assessing
accurate estimates for the individual components of the capitalization rate, which can be
challenging. The advantage of the build-up method is that it attempts to define and accurately
measure individual components of a discount rate.

The Market-Extraction Method

The market-extraction method assumes that there is current, readily available net operating
income and sale price information on comparable income-generating properties. The advantage
of the market-extraction method is that the capitalization rate makes the direct income
capitalization more meaningful.

Determining the capitalization rate is relatively simple. Assume an investor considers buying a
parking lot expected to generate $500,000 in net operating income. In the area, there are three
existing comparable income generating parking lot properties.

 Parking Lot 1 has a net operating income of $250,000 and a sale price of $3 million. In
this case, the capitalization rate is: $250,000/$3,000,000 = 8.33%.
 Parking Lot 2 has a net operating income of $400,000 and a sale price of $3.95 million.
The capitalization rate is: $400,000/$3,950,000 = 10.13%.
 Parking Lot 3 has a net operating income of $185,000 and a sale price of $2 million. The
capitalization rate is: $185,000/$2,000,000 = 9.25%.

Based on the calculated rates for these three comparable properties (8.33%, 10.13%, and 9.25%),
an overall capitalization rate of 9.4% would be a reasonable representation of the market. Using
this capitalization rate, an investor can determine the market value of the property. The value of
the parking lot investment opportunity is $500,000/.094 = $5,319,149.

The Band-of-Investment Method

The capitalization rate is computed using individual rates of interest for properties that use both
debt and equity financing. The advantage of the band-of-investment method is that it is the most
appropriate capitalization rate for financed real estate investments.

The first step is to calculate a sinking fund factor. This is the percentage that must be set aside
each period to have a certain amount at a future point in time. Assume that a property with net
operating income of $950,000 is 50% financed, using debt at 7% interest to be amortized over 15
years. The rest is paid for with equity at a required rate of return of 10%. The sinking fund factor
would be calculated as:
Plugging in the numbers, we get:

.07/12
{[1 + (.07/12)]15x12} – 1

This computes to .003154 per month. Per annum, this percentage is: .003154 x 12 months =
0.0378. The rate at which a lender must be paid equals this sinking fund factor plus the interest
rate. In this example, this rate is: .07 + .0378 = 10.78%, or .1078.

Thus, the weighted average rate, or the overall capitalization rate, using the 50% weight for debt
and 50% weight for equity is: (.5 x .1078) + (.5 x .10) = 10.39%. As a result, the market value of
the property is: $950,000/.1039 = $9,143,407.

How To Value A Real Estate Investment Property

Comparable Equity Valuations

Absolute valuation models determine the present value of future incoming cash flows to obtain
the intrinsic value of a share; the most common methods are dividend discount models (DDM)
and discounted cash flow (DCF) techniques. On the other hand, relative value methods suggest
that two comparable securities should be similarly priced according to their earnings. Ratios such
as price-to-earnings and price-to-sales are compared to other intra-industry companies to
determine whether a stock is under or over-valued. As in equity valuation, real estate valuation
analysis should implement both procedures to determine a range of possible values.

Calculating a Real Estate Property's Net Operating Income

The net operating income reflects the earnings that the property will generate after factoring in
operating expenses but before the deduction of taxes and interest payments. Before deducting
expenses, the total revenues gained from the investment must be determined. Expected rental
revenue can initially be forecasted based on comparable properties nearby. With proper market
research, an investor can determine what prices tenants are being charged in the area and assume
that similar per-square-foot rents can be applied to this property. Forecasted increases in rents are
accounted for in the growth rate within the formula.

Since high vacancy rates are a potential threat to real estate investment returns, either
a sensitivity analysis or realistic conservative estimates should be used to determine the forgone
income if the asset is not utilized at full capacity.

Operating expenses include those that are directly incurred through the day-to-day operations of
the building, such as property insurance, management fees, maintenance fees, and utility costs.
Note that depreciation is not included in the total expense calculation. The net operating income
of a real estate property is similar to the earnings before interest, taxes, depreciation, and
amortization (EBITDA).
Discounting the net operating income from a real estate investment by the market
capitalization rate is analogous to discounting a future dividend stream by the appropriate
required rate of return, adjusted for dividend growth. Equity investors familiar with dividend
growth models should immediately see the resemblance. (The DDM is one of the most
foundational of financial theories, but it's only as good as its assumptions. Check out "Digging
Into the Dividend Discount Model.")

Finding a Property's Income-Generating Capacity

The gross income multiplier approach is a relative valuation method that is based on the
underlying assumption that properties in the same area will be valued proportionally to the gross
income that they help generate. As the name implies, gross income is the total income before the
deduction of any operating expenses. However, vacancy rates must be forecast to obtain an
accurate gross income estimate.

For example, if a real estate investor purchases a 100,000-square-foot building, he may

determine from comparable property data that the average gross monthly income per square foot
in the neighborhood is $10. Although the investor may initially assume that the gross annual
income is $12 million ($10 x 12 months x 100,000 sq. feet), there are likely to be some vacant
units in the building at any given time. Assuming that there is a 10% vacancy rate, the gross
annual income is $10.8 million ($12 MM x 90%). A similar approach is applied to the net
operating income approach, as well.

The next step in assessing the value of the real estate property is to determine the gross income
multiplier. This is achieved if one has historical sales data. Looking at the sales prices of
comparable properties and dividing that value by the generated gross annual income produces
the average multiplier for the region.

This type of valuation approach is similar to using comparable transactions or multiples to value
a stock. Many analysts will forecast the earnings of a company and multiply the earnings per
share (EPS) figure by the P/E ratio of the industry. Real estate valuation can be conducted
through similar measures.

Roadblocks to Real Estate Valuation

Both of these real estate valuation methods seem relatively simple. However, in practice,
determining the value of an income-generating property using these calculations is fairly
complicated. First of all, obtaining the required information regarding all of the formula inputs,
such as net operating income, the premiums included in the capitalization rate, and comparable
sales data, may prove to be extremely time-consuming and challenging.

Secondly, these valuation models do not properly factor in possible major changes in the real
estate market, such as a credit crisis or real estate boom. As a result, further analysis must be
conducted to forecast and factor in the possible impact of changing economic variables.
Because the property markets are less liquid and transparent than the stock market, sometimes it
is difficult to obtain the necessary information to make a fully informed investment decision.
That said, due to the large capital investment typically required to purchase a large development,
this complicated analysis can produce a large payoff if it leads to the discovery of an
undervalued property (similar to equity investing). Thus, taking the time to research the required
inputs is well worth the time and energy.

The Bottom Line

Real estate valuation is often based on similar strategies to equity analysis. Other methods, in
addition to the discounted net operating income and gross income multiplier approach, are also
frequently used – some unique to this asset class. Some industry experts, for example, have an
active working knowledge of city migration and development patterns. As a result, they can
determine which local areas are most likely to experience the fastest rate of appreciation.

Whichever approach used, the most important predictor of a strategy's success is how well it is
researched.

Related Articles

FINANCIAL FUTURES TRADING

Calculating Fair Value in Futures Markets

TOOLS FOR FUNDAMENTAL ANALYSIS

What Determines a Company's Share Price?

REAL ESTATE INVESTING

How to Calculate the ROI on a Rental Property

REAL ESTATE INVESTING

What You Should Know About Real Estate Valuation

REAL ESTATE INVESTING

Rental Properties: Cash Cow Or Money Pit?

PRIVATE EQUITY & VENTURE CAP

Private Equity Jargon Explained
Partner Links

Related Terms

Enterprise Value – EV Definition

Enterprise value (EV) is a measure of a company's total value, often used as a
comprehensive alternative to equity market capitalization. EV includes in its calculation the
market capitalization of a company but also short-term and long-term debt as well as any
cash on the company's balance sheet.
more
How to Use the Income Approach to Value Real Estate
The income approach is a real estate appraisal method that allows investors to estimate the
value of a property based on the income it generates.
more
Home Inspection
Home inspection is an examination of the condition of a real estate property.
more
Gross Income Multiplier
The gross income multiplier is obtained by dividing the property's sale price by its gross
annual rental income, and is used in valuing commercial real estates, such as shopping
centers and apartment complexes.
more
Capitalization Rate
The capitalization rate is the rate of return on a real estate investment property based on
the income that the property is expected to generate.
more
The Operating Ratio – OPEX Tells Investors About a Company Management
The operating ratio (OPEX) shows the efficiency of a company's management by
comparing the total operating expense of a company to net sales. The operating ratio
shows how efficient a company's management is at keeping costs low while generating
revenue or sales.

How to Assess the Market Value of Property

by Jayne Thompson; Reviewed by Michelle Seidel, B.Sc., LL.B., MBA; Updated May 16, 2019

Related Articles
 1Calculate a Gross Income Multiplier
 2Assess Business Property
 3Define Real Estate Market Value
 4Pay an Appraised Value for Commercial Property

When it comes to buying or selling a property for your business, the starting point is to figure out how much the property is

worth. This seems simple enough – surely, you see what has previously been sold in your locality and use that as a jumping off

point? Sadly, the valuation of property – and especially commercial property – is not quite so straightforward. If it were, there

would be no need for professional appraisers in this field.

What Is Market Value?

Market value is a professional opinion of what a property would sell for at arm's length – meaning to an independent buyer,

without any concessions or kickbacks – based on the local real estate market, supply and demand, what other similar properties

are selling for in the area, and the specific features and benefits of the property.

This is not the same as the market price of a property, which can be more or less than the market value. That's because the price

is whatever the seller agrees to sell the property for. This could be the same as the market value, or the seller may accept a lower

price for the property because, for example, he needs a quick sale.

Three Different Methods of Valuation

There's also a much longer definition of market value, and that depends on the type of valuation method being used. There are

three primary methods of valuation in the United States: the sales comparison approach, the cost approach and the income

approach. Part of an appraiser's job is to know what method to use for a given property in a given location.

Before we look at the three approaches, bear in mind that a good percentage of a property's value is subjective. Deciding how

much a property is worth is more art than science, and certain parts of the process can be a little difficult to comprehend. You

could ask three different appraisers to value the same property and get three different answers.

This is especially true for a commercial property where scarcity might play a role in the property's valuation. The valuations

could be tens of thousands of dollars apart in some cases!

House Valuation Using the Sales Comparison Approach

The sales comparison approach is the most frequently used method for determining the value of residential real estate, although it

is also suitable for valuing some types of commercial properties. Using this approach, the property's value is based on what

similar properties have sold for recently in the same market. These properties are called "comparables" or "comps" – hence the

term sales comparison approach.

Here's how it works:

Note the Features of the Property

Start by listing the features and benefits of the property, for example:

 Square footage.
 Lot size.
 Location.
 Age.
 Numbers of bedrooms and bathrooms (if residential).
 If commercial, the best usage the property could be put to (for example, office, retail, warehouse).
 Overall condition (good, average, poor).

 Garages, pools, upgrades

anything that makes this property different from other properties in the community.

Find Comparable Properties

The next step is to find the sales prices of at least three properties that are comparable to the subject property. This means they

should share some, or ideally all, of the features you've listed. Make a note of any different characteristics, such as a lower

square footage – you'll need this information later.

If you have access to the Multiple Listing Service, you can easily pull up a list of comps. You're looking for properties that have

sold in the last three to six months – real estate markets move so quickly that older sale prices will be out of date. Pay attention

to the address of your comparable properties. Location is a key element in real estate appraisal, due to factors like transportation

and school quality, so you're looking for properties in the same neighborhood and ideally within a couple of streets of the subject

property.

If you don't have access to the MLS, you can find much of this information on Zillow; you'll just have to do a little more digging.

Calculate a Benchmark Price

Once you've found your comparables, run a quick calculation to get a benchmark valuation for the subject property. For

example, if you find three comparable properties that sold for $450,000, $480,000 and $435,000 respectively, you would take the

average of these figures – $455,000.

Another option is to find a price per square foot (ppsf), which is useful if your comps are bigger or smaller than your subject

property. For example, suppose the $450,000 property was 2,000 square feet (ppsf $225), the $480,000 property was 2,200

square feet (ppsf $218) and the $435,000 property was 1,950 square feet (ppsf $223). The average ppsf is $222. For a 2,300-

square-foot subject property, that would equate to a baseline valuation of $510,600.

Add Some, Subtract Some

As explained earlier, valuing property is more art than science – and this is the point where the valuation gets subjective. Physical

characteristics represent the most obvious differences between two comparable properties – one might be in better repair than the

other, or one may have a garage while the other does not. Therefore, you need to adjust the price up or down to account for

quality, condition, design and special features.

For instance, if a property on the next street sold recently but it had a view, whereas the subject property overlooks a brick wall,

you may have to scale down the baseline value of the subject property. It's rudimentary, but it's the best you can do absent the

experienced eye of a professional appraiser.

Land Appraisal Using the Cost Approach

The cost approach starts by calculating how much the property would cost to rebuild, either as an exact replica of the current

building or for the construction of a similar building with comparable features and amenities but with modern construction

materials.

The appraiser then deducts an amount for accrued depreciation, which represents the reduction in the value of the property over

time as a result of obsolescence or wear and tear. The theory here is that no one would pay more for an existing property than it

would cost to build the same property from scratch.

The cost approach is favored in newer construction or for valuing special-use properties where there aren't enough similar

properties for comparison. If you're valuing a commercial property, industrial property or bare land, then this is may be the most

reliable approach.

Here's how you do it:

Estimate the Value of the Land, Imagining It Vacant

Direct comparison is the most common method for estimating the value of vacant land – what have other plots recently sold for?

For example, use a land value estimator of $50,000.

Estimate the Cost of Constructing the Building

Ideally, you'll sum up the cost of all the separate construction components such as the roof, frame and plumbing. However, this

exercise is quite tedious and best left to cost estimators. Working with a lump-sum estimate per square foot is easier – a phone

call to an architect or a construction company could help you here.

For instance, if it costs a construction company $100,000 to put up a 2,000-square-foot warehouse, the rate will be $50 per square

foot. Multiply this rate by the building area of the subject property to obtain the construction cost. For example, suppose your

warehouse is 5,000 square feet. The estimated construction cost will be $250,000 (5,000 x 50).
Deduct an Amount for Depreciation

Depreciation represents the loss in value as a property ages over time, either due to wear and tear or loss of utility – a modern

office will be wired up to handle modern communication methods, for example, whereas a 40-year-old building may not be. The

simplest depreciation method is the age-life method, which estimates how far the property is along its useful life. For instance, if

the property is 10 years old and has a useful economic life of 40 years, the construction value should be depreciated by 25

percent. In this example, that leaves you with a construction cost of $187,500.

Find the Value

Finally, add the land value to the depreciated construction cost of the building. Here, the property value is $50,000 + $187,500 =

$237,500.

Income Approach for Leased Buildings

If the subject property is leased and income-producing, you have the option of valuing it using the income approach. This method

uses the property's rental income, or potential for income, to substantiate its market value. Apartment buildings and duplexes are

examples of properties that you might value using the income approach.

This method gets a little complicated, and whole books have been written on how to do it.

Here's the abbreviated version:

Determine the Net Annual Income of the Property

The net annual income is the lease income from tenants and occupiers. If the building is empty or partially empty, you'll have to

estimate this figure. Be sure to take vacancies into account. With a multi-unit apartment complex, for example, you might

estimate that 20 percent of the units will be vacant for at least one month of the year to allow for tenant turnover. As such, the

actual rental income will be lower than the headline figure, which assumes the building is always fully occupied.

For this example, imagine you're valuing an apartment complex that generates $500,000 in rental income per year.

Find the Net Operating Income

Net operating income equals revenue from the property minus all reasonably necessary operating expenses, such as maintenance,

utilities, property taxes, collections activity and property manager's fees. In this example, expenses add up to $100,000.

Consequently, the NOI works out to $400,000.

Establish the Property's Cap Rate

The capitalization or "cap" rate is the rate of return you're expecting to get from the property based on the rental income. The cap

rate formula is NOI divided by the value of the property. Here, you do not know the value of the property – since that's what
you're trying to calculate. You therefore have to work backward and start with the cap rate or yield you want to achieve for your

investment.

As a potential buyer, you might decide that an 8 percent yield is average in this market, and that's what you want to get from this

property purchase. If you can't negotiate a price that achieves that rate, then you'll look for a more profitable investment.

Run the Market Value of Property Calculation

Divide the NOI by the cap rate to arrive at the value of the property. The valuation for this apartment building would be $400,000

divided by 8 percent (0.08), or $5 million.

How to Calculate Property Value With

Capitalization Rate
Value Equals Net Operating Income Divided by Cap Rate
 Share
 Pin
 Email

The Balance

BY JAMES KIMMONS

Updated September 23, 2019

It's critical that real estate agents and brokers who work with investor clients understand income
property valuation methods if they're going to do their jobs properly. A commonly used valuation
method combines income and the capitalization rate to determine the current value of a property
being considered for purchase.

In addition to a property's market value, one of the first things you'll want to do as a real estate
investor who's considering buying a purchase is determine is its operating income and costs. This
information will tell you if the property meets your cash flow and profitability goals and expectations.

The Cap Rate

Cap rate represents your anticipated return after one year as if you had bought with cash.
Understanding cap rate is vitally important to your future business growth, particularly if you're just
starting out.

Calculate Property Value

First determine the net operating income (NOI) of your subject property. The NOI of a rental property
is its rents less its expenses. Determine the net rental income after what it costs to maintain the
building if it's an apartment complex.

This can be a bit of a challenge because you'll need the income and expense statements, and only
the current owner is likely to have this information. But you can also estimate NOI by multiplying the
sales price by the capitalization rate after you've nailed down the cap rate.

A Calculation Example

A six-unit apartment project might yield $30,000 net profit from rentals. Determine the capitalization
rate from a recent, comparable, sold property. Now divide that net operating income by the
capitalization rate to get the current value result.

Let's say your comparable sold for $250,000. You've determined that the property's NOI after
deducting applicable expenses is $50,000. Divide that by the $250,000 sales price. You have
a capitalization rate of .2, or 20%.

Assuming a capitalization rate of 20%, $30,000 divided by that percentage is $150,000. This would
be the current value.

Other Tools

Keep in mind that this isn't the only method for calculating income property values—it's just one tool
in the box. The various valuation and financial performance calculations that investors and real
estate professionals use in their daily routines all have some value.

For example, few properties are purchased with cash and no financing, so another calculation
method used might be a cash-on-cash return.

There are books full of complicated calculations you can use to value real estate and determine the
performance of real estate investments and rental property ownership and operations. Some apply
to wholesaling, some to fix-and-flip projects, while still others apply to rental investing. Some are
more useful to the rental investor in determining the long-term performance of their portfolios.

Most investors only use half a dozen or so of these calculations regularly for
residential property investment.

Commercial Property Investment

A whole new level of math is involved in commercial investment. Lenders use some very specialized
calculations to determine whether to finance purchases or projects.

Choosing which valuation and profit calculations to use depends on your goals and the property
type. You probably won't be all that interested in cap rate and other multi-family-oriented calculations
if you're an investor buying single-family rental properties.

Rental Property Investment

The beginning of a successful rental property investment strategy is an accurate estimate of rental
yield for the prospective property. The net rental yield tells you just how well your investment is
doing, not only with market factors and rent included, but also with your costs, including
management and maintenance.

The Bottom Line

Those who invest in real estate via income-producing properties should have a method to determine
the value of any property they're considering buying. Cap rates are widely used in commercial and
multi-family property valuation and profitability studies. They can be used to determine a good sales
price, or the value of a listed property versus the asking price.