(This advanced blog summarizes real estate investing tips and insights Lofty AI has acquired from working with thousands of investors and institutional funds.)
The 4 property valuation methods
This post teaches you the 4 most commonly used property valuation and real estate appraisal methods.
Property valuation is important to calculate and understand before the purchasing of a property. While some signs, like location and square footage of a property, are important to finding out the ultimate value of the property, they can also be misleading. These nuances can make a potential property seem like a better investment than it actually is.
Using calculations and careful estimates based on the values of the neighboring properties can help you to see if a property for potential investment will meet your investment goals. Read on to find out about the best ways to run valuation on a property.
There are 3 traditional methods to run a valuation on property:
- Comparable sales approach
- Income approach
- Cost approach
The 4th method is Lofty AI’s approach to determining property valuations. Let us start with the traditional methods first.
If you already know these, then you can skip to the end to read about the new solution from Lofty AI.
Comparable sales approach
The comparable sales approach identifies past transactions of comparable properties, or rental comps. It then uses these rental comps as a benchmark to determine the value of a property.
The first step is finding nearby properties that are similar to the subject property, that have also been recently sold.
Otherwise known as comparable properties or "comps".
To provide a valid comparison, each rental comp must:
- Be as similar to the subject property as possible in terms of property type, square feet, number of beds/baths, etc.
- Have been sold within the last year in an open, competitive market
- Have been sold under typical market conditions
You want to use at least three or four comps in your real estate valuation process. You should also take into account the state of the comps (recent upgrades, new amenities, etc.) and most importantly, the location. Location can have a huge effect on the valuations of property.
Location can look good at first glance, especially if there are young families and attractive features in the neighborhood, but it can be deceptive when calculating the long term valuation of a property.
No two properties are exactly the same. Because of this, you want to make adjustments to the comp prices to account for dissimilar features.
You also want to account for other factors that would affect value, including:
- Property size
- Lot size
- Property age and condition
- Physical features and amenities, including landscaping, type and quality of construction, number and type of rooms, square feet of living space, hardwood floors, a garage, kitchen upgrades, a fireplace, a pool, central air, etc.
- Location desirability
- Proximity to property in question -- the closer, the better. You especially will want to rule out comps on the other side of a busy street, as there tends to be large discrepancies. It might even be better to look at the houses down the street rather than the one directly across the street.
- Date of sale (Remember: the more recent, the more accurate)
The valuation for the subject property will fall within the range formed by the adjusted sales prices of the comps.
Keep in mind a portion of the adjustments made to the sales prices of the rental comps will be more subjective than others. This method for property valuation can be the most subjective and inaccurate due to guesswork that is employed here.
Because of that, weighted consideration is commonly given to those comps that have a minimum amount of adjustment.
The income capitalization approach, or income approach, is a valuation of real estate commonly used for rental properties and commercial real estate properties. This method converts the income of a property into an estimate of its value.
Since you are here to learn about investing in real estate rentals, this is a good method to use.
The general formula for calculating the valuation of a property, also known as IRV in this method, is as follows:
Net operating income (I) / capitalization rate (R) = value (V)
Breaking this calculation into a few extra steps is helpful. First calculate the NOI, as follows:
How to Estimate the Net Operating Income
1. Calculate the annual potential gross income
The potential gross income is the potential rental income of the property when rented at 100% capacity.
For example, if the monthly rent is $1,000 then your annual potential gross income is 12 x $1,000 = $12,000.
2. Calculate the effective gross income
This number, which usually is expressed as a percentage, is the appraiser’s estimate from the market for these kinds of buildings in the local area. The effective gross income is the potential gross rental income plus other income minus the vacancy rate and credit costs.
For example, the vacancy rate of property could be 5% and the additional income might be $100 per month, or $1,200 annually.
At this point: A property with a potential gross income of $12,000 - 5% vacancy (or $600) + additional income (or $1,200) = $12,600
3. Calculate the net operating income (NOI)
Start by deducting annual operating expenses such as real estate and personal property taxes, property insurance, management fees (on or off-site), repairs and maintenance, utilities, and other miscellaneous expenses (accounting, legal, etc.).
Effective gross income - operating expenses = NOI
At this point: Our Effective gross income is $12,600 for this property. Let’s say all the additional operating expenses are $10,100 for the property. This means the NOI is $2,500.
Now that you have your NOI calculated, you can continue on to estimate the valuation of your chosen property.
4. Compare similar cap rates
A capitalization rate is similar to a rate of return; that is, the percentage that the investors hope to get out of the building in income.
Look at similar properties’ cap rates to estimate the price an investor would pay for the income generated by the particular property.
Let’s choose a cap rate of 10% for this example.
5. Apply the cap rate to the property’s annual NOI
This last step allows you to form an estimate of the property’s value, and where the formula is used.
All you have to do now is divide the NOI by the cap rate.
To finish the example: $2,500 / 0.10 = $25,000
$25,000 is the estimate of the valuation of this property, using the income capitalization approach.
- The income approach is a real estate valuation method that uses the income the property generates to estimate fair value.
- It is calculated by dividing the net operating income by the capitalization rate.
- This method requires the most calculations to be done, which can be tricky, but gives some of the most accurate results.
- When using the income approach, a buyer should pay special attention to the condition of the property, operating efficiency, and vacancy rates.
- If you chose to use this approach, Lofty AI’s ROI calculator would be a helpful tool.
The cost approach assumes the price a buyer should pay for a piece of property should equal the cost to build an equivalent building.
The market price for the valuation property is equal to the cost of land, plus cost of construction, less depreciation.
It yields the most accurate market value when the property is new.
The cost approach does not focus on comps or income generated by the property like the two methods previously described.
Instead, the cost approach values real estate by calculating how much the building would cost today if it were destroyed and needed to be replaced. It also factors in how much the land is worth and makes deductions for any loss in value, otherwise known as depreciation.
The thought process behind this approach is that it makes very little sense for buyers to pay more for an existing property than what it would cost to build from scratch.
When using this method, it is important to remember that it can be helpful when calculating the valuation of a property, but it does not take into account the surrounding factors or the factors of that specific property, which as we have previously said, can skew your results dramatically.
The most commonly used cost approach appraisals include:
- Reproduction cost - The cost to construct an exact duplicate of the subject property at today’s costs.
- Replacement cost - The cost to construct a structure with the same usefulness (utility) as a comparable structure using today’s materials and standards.
When all estimates have been gathered, the cost approach is calculated in the following way:
Replacement or Reproduction Cost – Depreciation + Land Worth = Value of the Property.
The cost approach works best on the following property types:
- Rural properties - When there are no other properties nearby, it is impossible to value a property via the sales comparison approach.
- New construction - The cost approach is often used for new construction, too. Construction lenders require cost approach appraisals. This is because any market value or income value is dependent upon project standards and completion.
- Special use properties - Includes schools, government buildings, and hospitals. These properties generate little income and are not often marketed. This invalidates the income and comparable approaches.
- Insurance - Insurance appraisals tend to use the cost approach. This is because only the value of improvements is insurable and land value is separated from the total value of the property.
- Commercial properties (sometimes): The income approach is the main method used to value commercial properties. But, sometimes a cost approach may be implemented when design, construction, functional utility, or grade of materials require individual adjustments.
Lofty AI approach
At Lofty AI, we have found that focusing on a residential property's surrounding neighborhood, rather than the property itself, gives us a better representation of what a property is actually worth.
This is because it is almost impossible to know what is going on inside of a house or in the backyard. This includes renovations, a new home theater, a new pool, etc.
Almost all AVM's (Automated Valuation Models) in the real estate tech space, including the Zestimate, are focused exclusively on property specific features and comps. They are basing their models on property features and pictures of the property that were updated the last time it was sold, which could have been 10 years ago, to predict what the home should sell for today.
All the other approaches that have been mentioned in this article estimate the valuation of a property based on property features, rather than features surrounding the property.
Our AVM pairs property specific features and comps alongside more nuanced, neighborhood data such as Airbnb prices nearby, population growth of younger generations and new businesses in the area, real-time crime data, and much more.
This activity we are picking up in the micro-neighborhood around the property allows us to formulate a much more accurate prediction. And not only a more accurate prediction of what a property is worth today but what it will be worth in the near future as well. The rest of the methods for calculating a property’s valuation are more focused on the current value, and would take additional research and calauctions to get future estimates.
Our AVM gives clear and concise results, as well as a rating out of five. The higher the rating, the more money the property should sell for above its listing price. We use our AVM to score every approved property on our real estate investment app via the scale below:
If you are looking to buy a house to rent out, you can request access to our real estate data science platform by clicking the button below.
Once you gain access, you will instantly be able to instantly see all of the undervalued properties, cash flowing properties in your area, using our AVM, or even our ROI calculator.
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