Three Approaches to Valuation
Hey, welcome back!
There’s a saying in real estate that says, “You make your profits when you ‘buy,’ not when you ‘sell’ the property.” But to buy profitably, you have to be able to value accurately. To do that, we have three valuation approaches to explore.
The Cost Approach
The cost approach to valuation makes a simple assumption that a potential user of a property will not (and should not) pay more for a property than it would cost to build an equivalent property from scratch. That is, the value of the property is the cost of land plus the cost of construction, less depreciation.
For example, let’s say you’re looking at a 1600 sq.ft. property for purchase, and you get these cost figures if you were to build an equivalent unit in the same area:
• $200K for building equivalent dwelling (1600 sq.ft. @ $125/sq.ft. cost of construction)
• $15K for upgrades to match granite kitchen
• $15K for extra garage (500 sq.ft. @ $35/sq.ft.)
Total new construction is $230K. But the subject house you’re looking at has aged and lost some of its useful life. So, we factor in some depreciation:
• 35% physical depreciation ($80K)
• 10% functional depreciation ($23K)
Total depreciated value is $103K.
Finally, we add the cost of the raw land ($40K) and any addition improvements ($20K) (e.g., new roof). Adding all this up, we arrive at a market value of $187K using the cost approach.
The Comparable Sales Approach
For residential homes, condos, townhouses, and small rental apartment buildings, the comparable sales approach often provides a great estimate of market value. If you want the probable price of a specific property will likely sell at, find out the selling prices, the deal terms, and features of recently sold similar properties near the target property. The more closely the comparable properties resemble your target property and the closer in proximity, the better and more accurate your estimate will be using this approach.
Let’s look at an example of using five market comps, recently sold, 1600 sq.ft. properties, in the same neighborhood as our target property:
• Comp #1: $200K
• Comp #2: $160K
• Comp #3: $190K
• Comp #4: $220K
• Comp #5: $180K
If we add them all up and take their average, we arrive at an estimate of $190K using the comparable sales approach.
In practice, the comps are never identical to our subject property, so we would need to make adjustments for age and square footage, as well as a host of other amenities or features that either add or subtract value in the market.
The Income Approach
Lastly, we have the income approach, which is an appraisal technique that is also often called the Gross Rent Multiplier (GRM). To calculate the GRM, you need to know the monthly rents and sales prices of similar properties that have recently sold. For this reason, the method only works for income-producing properties.
• Comp #1: $200K Sale Price, $1,500 Monthly Rent → GRM (200K/1500) = 133.33
• Comp #2: $160K Sale Price, $1,200 Monthly Rent → GRM (160K/1200) = 133.33
• Comp #3: $190K Sale Price, $1,600 Monthly Rent → GRM (190K/1600) = 118.75
• Comp #4: $220K Sale Price, $1,600 Monthly Rent → GRM (220K/1600) = 137.5
• Comp #5: $180K Sale Price, $1,400 Monthly Rent → GRM (180K/1400) = 128.57
Taking the average, we arrive at a GRM of 130.3. Then, depending on the rent we think our subject property could achieve, we multiply it by this average GRM to arrive at the value estimate. For instance, if we think the property could achieve a rent of $1,500, then the estimated value will be $1,500 * 130.3 = $195.4K.
Just like the comps approach, this requires you to be able to find very similar properties in the same neighborhood. GRMs can vary widely by city and even from neighborhood to neighborhood. So, it’s important to run the analysis each time, using the best comps possible.
I recommend that you start with the comparables approach. Especially when you can get recent transactional data for similar properties, the comparable approach often yields the most accurate estimate for the market value of a property. It is also easier to obtain transactional data than get accurate costs estimates for new construction.
Tomorrow, we’ll start a case study following the decisions of Joe the investor, using real market data.