About the author: G. Brian Davis is a real estate investor who has owned dozens of investment properties over the last 15 years. He’s also the co-founder of SparkRental.com, an online resource which provides free landlord education and video series for anyone looking to build passive income from rentals.

What is a property worth?

Answering that question is key to making profitable offers, and more importantly, to predicting your profits from real estate investments. But while it’s a simple question, it doesn’t always have a simple answer.

Here’s what real estate investors need to know about property valuation to help them accurately assess values before making an offer. When investors know exactly how much a property is worth currently, how much it will cost to renovate, and how much it will be worth after the repairs, they know how much they can expect to earn from a deal. Learn how to assess properties like appraisers do, including the three most common real estate valuation methods used in house appraisals to more accurately project profits for any deal.

Property valuation overview

Buying real estate is not like buying groceries or electronics or other goods and services. Properties don’t have a fixed price tag, and for that matter, they don’t have a fixed value. Like stocks, their values constantly shift based on what buyers are willing to pay for them. Yet value and price are not always the same thing in real estate.

Value vs. Price vs. Cost

When property owners plan to sell, they list the property for sale for an asking price. But buyers can and do make lower offers at a different price point.

Ultimately, the price that a property sells for may or may not accurately reflect its value. Imagine two identical homes, right next to each other. One sells for $200,000, similar to other neighborhood homes. The other sells for $100,000, from a father to his daughter–a price which has nothing to do with fair market value.

Likewise, value and price often differ from a property’s replacement cost. A beautiful 200-year-old home may have a $500,000 market value based on what current buyers are willing to pay, but if it burned down, it might cost $600,000 to build an identical replacement based on today’s material and labor costs.

In short,

  • Price is what a buyer actually pays
  • Cost is what it would cost to build a replacement home today
  • Fair market value is what a stranger would theoretically be willing to pay for a home based on today’s demand for similar housing

Different types of value

Not all real estate valuation is created equal. Most commonly, value refers to “fair market value” outlined above. However, different types of buyers and sales methods can produce other types of values:

  • Liquidation value aims to estimate what price a property would bring at auction, if forcibly sold (e.g. through foreclosure or bankruptcy). Liquidation value is nearly always lower than fair market value.
  • Value-in-use is the value of a specific use of a property to a specific owner. For example, if a property is currently used as short-term vacation rental property by a small business, its value-in-use is based on their revenue and may be different from the fair market value that a homebuyer would be willing to pay.

Who evaluates properties and how much do valuations cost?

In addition to the transacting parties, there are several industry professionals who conduct inspections and offer input tot the seller, buyer, and lender.

  • Realtor: When first hiring a realtor, the seller typically asks the realtor’s opinion on value and listing price. This opinion could be verbal and informal (often called a comparative market analysis or CMA), or it could be delivered in an official report as a broker price opinion (BPO).  While not as thorough as an appraisal, BPOs may be completed faster and cost less, usually between $125 and $225 when ordered separately and may be completed by a professional who could be a real estate agent, a real estate broker, an appraiser, or other qualified person.

Broker price opinions are most commonly ordered by lenders who wish a quick estimate of value on a property headed for foreclosure or loan modification. Realtors often do not charge property owners for a CMA or BPO, if completed as part of a listing agreement.

  • Home Inspector: Upon signing a contract with a seller, the buyer typically orders a home inspection and an appraisal. Home inspections are extremely thorough and often takes several hours to complete. The home inspector evaluates the building’s structure, foundation, roof, mechanical systems, wiring, and functional age. Home inspections range in cost from $300-450, depending on the size of the home. Buyers use this information to confirm that the property is in the condition they expected when they made their offer. Obviously, a home’s condition affects its value, and if the home inspection reveals a major structural problem in the foundation, then the property’s value will reflect the needed repairs. Read up on additional ways to make the most of a home inspection here.
  • Appraiser: Ideally, the home inspection should be performed before the house appraisal, so the appraiser can review the home inspection report and take it into account when forming the property valuation. The typical cost for a house appraisal ranges between $300-400. While the home inspector’s job is to assess the condition of the property and any needed repairs, the appraiser’s job is to estimate its value using one of three valuation methods below.

3 Real estate valuation methods

Appraisers use three real estate valuation methods when determining a home’s value: the sales comparison approach, cost approach, and income capitalization approach.

Real estate appraisal method 1: The sales comparison approach

The most common way appraisers estimate a property valuation is by analyzing nearby comparable properties (“comps”).

It makes intuitive sense: if you want to how much one property is worth, and an identical property just sold next door, that’s a pretty clear indication of value as long as it was an “arms-length transaction”—unlike the father-daughter example above.

Of course, rarely do you have identical properties selling just next door within the last few months. More often appraisers must simply find the most similar properties they can, as near as possible, and selling as recently as possible.

Here are a few factors that appraisers must account for when reviewing comps:

  • Home size
  • Lot size
  • Home age and condition
  • Home amenities
  • Location desirability
  • Proximity to home in question (the closer, the better)
  • Date of sale (the more recent, the more accurate)

Due to these variations in comps, property valuation is not an exact science. For example, what’s a more accurate comp: a property across the street that has more bedrooms and sold nine months ago, or a property with a similar layout ten streets away that sold last week?

This is why three different appraisers would come up with three different values for the same property, if hired to do so. House appraisals are an estimate of value only, not a guarantee of a specific price. Learn all you can about how to use comps to determine home values, so that you can analyze property values without having to constantly ask realtors or appraisers for help.

Example:

Andy Appraiser wants to estimate a home’s current value. The home in question has three bedrooms, two full bathrooms, and 1,500 square feet.

He looks at nearby homes that have sold recently and finds three similar comps that sold within the last four months:

Comp 1: 3 bedrooms, 2 bathrooms, 1,350 square feet. Sales Price: $195,000.

Comp 2: 4 bedrooms, 2 bathrooms, 1,650 square feet. Sales Price: $235,000.

Comp 3: 3 bedrooms, 2 bathrooms, 1,450 square feet. Sales Price: $205,000.

Andy estimates the property value at roughly $205,000-$210,000, having verified that the condition of all three homes was similar to his property in question.

Real estate appraisal method 2: The cost approach

When compiling a house appraisal, the appraiser can’t always find similar comps. For example, a rural house with no nearby homes can be difficult to value through the sales comparison approach. Unique properties, such as castles or converted churches, are also difficult for property valuation by comps, since they’re, well, unique!

An alternative real estate appraisal method is the cost approach. How much would it cost to buy the land and build the home?

Of course, the appraiser must take into account the property’s current condition. Building a new home from scratch would result in a perfect new house, and the existing house is likely not in perfect, new condition. So, appraisers use a technique called depreciation to estimate how much less the current home is worth, compared to an identical brand-new house.

Some of the factors appraisers consider for depreciation include:

  • The home’s physical deterioration: examples include old mechanical systems, old appliances and fixtures, and the condition of the roof, foundation, and other structural components.
  • Functional obsolescence: an outdated way of building or structuring homes. For example, an upstairs layout where the only way to reach one bedroom is to walk through another.
  • Economic obsolescence: neighborhood or other location-based factors that leave the property less valuable. An example is if a six-lane freeway was recently built right next to the property.

So, the appraiser uses comparable sales to estimate the value of the land itself, then estimates the cost of construction to replace the building. Finally, they estimate the amount of depreciation and subtract that from the value, to reach a property valuation by cost method.

Example

Andy Appraiser has been hired to draft a house appraisal on a castle sitting on 100 acres. After reviewing sales of nearby undeveloped land, he estimates the value of local land at $5,000 an acre, which puts the land’s value at $500,000.

Andy then estimates that it would cost $200 per square foot to build a new castle using the same materials. The castle has 10,000 square feet, putting the replacement cost at $2,000,000.

But the castle needs significant renovations to be returned to like-new condition. Andy estimates renovation costs at $300,000, based in part on the home inspection report he received.

Thus, Andy calculates the castle’s value like this:

Land: $500,000 +

Building replacement cost: $2,000,000 –

Depreciation: $300,000 =

Value by cost: $2,200,000

Real estate appraisal method 3: The income capitalization approach

The value of certain properties, such as apartment buildings or office buildings, lies in their ability to generate income.

For these properties, it makes sense to estimate their value based on their income potential. There are two ways to do this: direct capitalization and gross income multiplier.

Direct capitalization is used for apartment buildings and commercial properties. To determine it, the appraiser first calculates the net operating income (NOI) for the property, by adding up all annual rents (gross income) and subtracting all expenses (including vacancy rate, management costs, maintenance, repairs, taxes, insurance, and so forth).

They then look at similar properties’ capitalization rates, and multiply the NOI by the cap rate multiplier to reach a value estimate (example below).

Gross income multiplier is often used for single-family rental properties and small multifamily rentals. The appraiser looks at the relationship between local rents and local home prices, to determine how many times the monthly rent investors are paying as a purchase price. Once they find the typical local income multiplier, they can multiply the property’s rent by this multiplier to determine an estimated value.

Examples

Andy the Appraiser needs to appraise a four-unit rental property. He tries both income property valuation methods.

Using the direct capitalization approach, he uses the following math:

Gross annual income: $48,000 ($4,000/month) –

Annual expenses: $20,000 =

NOI: $28,000

Local cap rate: 8%

Estimated value: $28,000 x (100/cap rate) = $350,000

Then he uses the gross income multiplier method. He finds that local rental properties are selling for around 85 times the rent. So, this calculation goes as follows:

$4,000 monthly rent x 85 = $340,000

Similar, but not exactly the same, as the direct capitalization approach. It’s up to Andy’s best judgment which is the more appropriate and accurate calculation in this case.

What flippers need to know about property valuation

One of the first lessons for flippers learning how to invest in real estate is to invest based on hard numbers, not emotions. Specifically, they need an accurate estimate of their costs, and accurate estimate of the after-repair value (ARV).

Costs include the acquisition costs (purchase price, closing costs), cost to renovate the house (materials, labor, and other scope of work costs), and soft costs (such as carrying costs and other non-renovation costs).

But most relevantly here, flippers need to be able to estimate the ARV accurately.

For single-family homes to be flipped to homebuyers, investors can nearly always use the comparable sales approach as their real estate valuation method, both for the current value and the ARV. The appraiser will also follow this approach when the flipper or lender orders the house appraisal to first buy the property.

For properties intended to be flipped to buy-and-hold income investors, investors and appraisers sometimes use the income approach since the property’s use will be generating income. It’s uncommon for flipped properties to require a cost method appraisal.

As a crude shorthand, flippers can use the 70% rule to determine how much they should offer on a property, based on their costs and the ARV.

Final word

When you go to buy a home to flip, the bridge lender will require an appraisal. But you should have your own accurate estimates of both the current and after-repair values.

LendingHome provides bridge loans based on up to 90% of the property’s current value and 100% of the renovation costs. Before submitting an offer and a loan application however, run your own analysis of the property’s value, and make sure you’re confident in the numbers.

When you can accurately forecast costs and the ARV, you’re virtually guaranteed to earn a profit as a real estate investor.

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Disclaimer: The above is provided for informational purposes only and should not be considered tax, savings, financial, or legal advice. Please consult your tax advisor. All calculations and information shown here are for illustrative purposes only. All third parties listed above are for demonstration purposes only and are not affiliated with LendingHome. All views and opinions expressed in this post are the  author’s own. NMLS ID: 1125207 Terms, Privacy & Disclosures. Copyright LendingHome Corporation 2019.