When it comes to real estate investing, the first thing that comes to a real estate investor’s mind is how much money should I pay for a piece real estate I am considering. Below are a few commonly used methods investors use to determine value.
- The Income Approach, (Cap Rate):The income approach is a property valuation method that is particularly common in rental properties. The main idea behind the income approach is to calculate the current value of a piece of real estate based on the net income it generates.
- This is done by determining the gross potential income. The total income a piece of real estate generates with a 100% occupancy.
- To determine Net Operating Income (NOI) deduct estimated vacancy costs based on similar properties in the local area. This figure reflects the normal loss of income caused by probable vacancies for a property of the nature you’re considering. Also, deduct property expenses, such as property taxes, insurance, management fees, repairs, or other expenses the owner of the property would be responsible for.
- The Capitalization Rate (Cap Rate) is the Purchase price divided by the NOI, (A property with a NOI of $20,000 that sells for $200,000 has a CAP rate of 10%).
2- The Sales Comparison Approach: The sales comparison approach uses the market data of recent closed sale prices to estimate the value of real estate. This method is done by comparing a property to other comparable properties that have recently sold. Comparable properties, also known as comps, must share common features with the property in question. Some of these include physical features such as square footage, number of rooms, condition, and age of the building. An additional important factor is typically the location of the property. Since no two properties are exactly alike adjustments are usually needed to account for differences in the comps.
The sales comparison approach is commonly used for residential properties where there are typically many comparables available to analyze.
3-The Cost Approach: The cost approach is a real estate property valuation method which considers the value of a property as the cost of the land plus the cost of replacing the property (construction costs) minus the physical and functional depreciation. This approach is most commonly used for real estate properties that are not easily sold like schools, hospitals, and government buildings. Land cost can be estimated using the sales comparison approach by studying recent sales of land close to the subject property, and these sales should be comparable in size and location. There are different ways to estimate replacement costs, the most common being finding out the cost to build a square foot of comparable properties multiplied by the total square footage of the building.
4- The 1% Rule: This is a quick and simple calculation that multiplies the purchase price of the property plus any necessary repairs by 1% to determine Gross Rent. The closer the actual Gross Rent for the property is to the 1 percent calculation of rent the better. This rule is only used for quick estimation because it doesn’t consider other costs associated with a piece of property, such as vacancy factor, maintenance, insurance, and real estate taxes, ect.
5- Gross rent multiplier, which uses the monthly rent level to determine the amount of time it will take to pay off the investment. This calculation is achieved by dividing the total borrowed value by the monthly rent. An investor considering a home with a value of $200,000, and rent of $2,000.00, would divide $200,000 by $2,000. This gives the investor a 100-month payoff period, which translates to a little over 8.3 years.
6- The 70% rule states an investor should not pay more than 70% of the property’s estimated value after repair costs.