Real estate valuation for single family homes is typically done by using comparable sales. This basis however is not as effective in the case of rental properties. Imagine if you are looking at a 24-unit building. It would be difficult to find similar ones nearby that have recently sold.
Likewise, using replacement costs as the basis for appraisal is impractical. It will work only if there is a recent sale of a land recorded in a properly zoned area. On the other hand, this method will be useful if you are making a decision on whether to buy or build.
The Cap Rate as the Basis of Property Valuation
The income motive is the reason for the purchase of income properties. Income, then, is what is used to determine value. The cap rate (capitalization rate) is the expected return on the investments of the property owner in that area. This is one approach when making an evaluation of the value of an income property. Below is a somewhat simplified explanation.
Compute the gross annual income of the property. You then subtract all expenses, but not loan payments. For example, if a building’s gross income is $82,000 per year, and the expenses $30,000, you have a net (before debt-service) of $52,000. Then divide this figure with the capitalization rate.
If the cap rate in the area is estimated at say 0.10, then your expected return on your property value would be ten percent. What you do then is divide your $52,000 net income with .10 which would give a market value of $520,000 for your property. Supposing further that the property investors in the area presuppose an 8% ROI. Your property then will be valued at $650,000.
Easy Real Estate Valuation?
Take net income before debt-service, and divide by the “cap rate:” It’s a simple formula. The important factor therefore would be the accuracy of the assumed income. Did the seller show you ALL the normal expenses? Did he and exaggerate the income? What if he stopped repairs for a year and projected a gross rental income? Your income would be overvalued by as much as $15,000. If the cap rate used is .08, then the appraisal is overstated by $187,000.
Experienced investors do not include incidental income from vending and laundry machines and other sources. If incidental income accounts for $6,000, that would result to an overvaluation of $75,000 based on the .08 cap rate. A more favorable process would be to exclude incidental incomes from the gross, and to include the replacement costs of the machines (should be less than $75,000) to get the appraised value.
Of course, you should be careful with any real estate appraisal method. Considering that there is no perfect procedure for every situation, be sure to get the right figures in order to get the right answers. If used wisely, though, appraisal by capitalization rates is one of the most accurate methods of real estate valuation.
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