(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.
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's save that for last.
The comparable sales approach identifies past transactions of comparable properties, or rental comps. It then uses them 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.
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 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’ll want to rule out comps on the other side of a busy street, as there tends to be large discrepancies.
- Date of sale (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.
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.
Appraisers will perform the following steps when using the income approach:
1. Calculate the annual potential gross income
The potential gross income is the potential rental income of the property. 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
The effective gross income is the potential gross rental income plus other income minus the vacancy rate and credit costs. For the vacancy rate, assume 5% per year.
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.).
4. Compare similar cap rates
Look at similar properties’ cap rates to estimate the price an investor would pay for the income generated by the particular property.
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.
- The income approach is a real estate valuation method that uses the income the property generates to estimate fair value.
- It's calculated by dividing the net operating income by the capitalization rate.
- When using the income approach, a buyer should pay special attention to the condition of the property, operating efficiency, and vacancy rates.
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.
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's 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
We’ve 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's nay impossible to know what's 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're 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.
Our AVM pairs property specific features and comps alongside more nuanced, neighborhood data such as Airbnb prices nearby, population growth of hipsters, millennials, and artists in the area, real-time crime data and much more.
This activity we're 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.
We use our AVM to score every approved property on our real estate investment app via the scale below:
If you're 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'll instantly be able to instantly see all of the undervalued properties, cash flowing properties in your area.
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