It’s no secret that real estate investments present a stable, long-term opportunity to grow wealth and gain an avenue of passive income. But before jumping into the market, it’s critical to know whether or not a property represents a good or a bad value. How is property valuation calculated? More importantly, how can you use real estate valuation methods to your advantage?

Before investors start shopping, they need to understand how properties are evaluated and ultimately given an agreed-upon value. Here’s what you need to know about property valuation.

What is property valuation?

In its most simple terms, property valuation is the process by which real estate is evaluated for several purposes. Generally speaking, valuations are determined by licensed appraisers and real estate brokers with a broker opinion of value, or BPO.

Real estate Is evaluated on several different levels. The square footage of the property, floor plan, improvements, structural condition, and amenities can all go into the home’s value. Additional factors, such as the location, local school district, and market conditions, can affect the value and also the sales price.

Why is property valuation important?

Property valuation is important for many different reasons. When it comes time to buy or sell the house, real estate valuation can ultimately affect its price and the number of bidders on the property.

For investors, an independent property valuation is important because understanding the starting value allows them to calculate the starting cap rate, as well as the potential for growth. Without the cap rate or projections on cash-on-cash returns, an investor has no idea how much risk they would absorb on the potential rental property.

Although sellers may come up with their own valuation through experts or their own calculations, potential investors should also do their own research as well. Only through thorough investigation can investors make an educated decision about which opportunities will fit well within their investment plans.

The Real Estate Valuation Methods You Should Know

When it comes time to evaluate any given property, there are three key methods investors use to determine real estate valuation. The most common methods include the income approach, the sales comparison approach, and the cost approach.

  • The Income Approach

    The income approach, more formally known as the income capitalization approach, considers the value of a property from the investor’s perspective. This method balances the rate of return an investor expects from the real estate with the estimated net income it would produce.

    Some investors prefer the income approach because it projects the cash-on-cash rate of return for the buyer. This valuation is most commonly used for commercial properties because it puts the emphasis on how quickly buyers can make their money back. However, this approach can also be used for residential properties that will ultimately be used as rentals.

  • The Sales Comparison Approach

    In the sales comparison approach, property valuation is determined by looking at surrounding properties in the area. Not only is sales data from the same neighborhood evaluated, but also similarly sized houses sold over the past year under typical marketing conditions. For this market based real estate valuation, investors will often look at three to four properties at the same age, physical features, and sales terms to understand the current and future potential return.

    The sales comparison approach is most often used for single-family homes because it allows investors to make an apples-to-apples comparison of their opportunities based on actual market data. By looking at similar properties, potential buyers for all kinds of homes – including HUD homes – can see how supply and demand have changed alongside sales value. This projects not only how much owners could demand for rent but also how much their value will grow over time.

  • The Cost Approach

    For new or re-developing neighborhoods, the cost approach can help investors determine property valuation based on improvements. The cost approach can be complex because it requires multiple independent appraisals. The value of the land, structures built upon it, and any improvements or additions. From there, devaluation is added into the mix, which then leads to the final real estate valuation. The cost approach is useful for those who are determining if they should purchase an existing building or if it would be more cost effective to build a new, similar building.

    The cost approach is not commonly used for residential property valuation because investors do not usually elect to construct new rentals instead of purchase existing conditions. This method is most effective for properties that are not commonly purchased or sold or those used by not-for-profit entities. Churches, hospitals, and other similar buildings are often constructed for community use are best evaluated using the cost approach.

Conclusion

As with any security, investment properties should be carefully evaluated to determine their real estate valuation. All investments are not guaranteed to produce income and can lose value over time. By understanding the three different property valuation approaches, and how they are applied to buildings for sale, buyers can make better decisions on which opportunities will help them achieve their wealth building and financial goals.

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