A property valuation is the estimated value of a property’s worth at a particular moment. Investors then use the estimate for legal, financial, or transactional purposes. Although professionals usually perform an appraisal, understanding the methods of real estate valuation is important for all real estate investors.
Knowing how to perform a rough estimate will help you evaluate properties, make informed decisions about your portfolio, and set competitive rental prices. Today, we’ll cover the basics of property estimations and the three common methods investors use to assess properties.
Key Insights
- Real estate valuation is different from a property’s list price. A valuation is the property’s actual worth based on predetermined factors. Unlike the list price, this estimate considers the potential for growth over time for investments.
- A property appraisal can cost several hundred dollars, but it’s worth the investment. You’ll receive an accurate picture of the property’s worth. That puts you in a better position to negotiate the list price.
- Valuation is important at every stage of your journey as a real estate investor, from your initial purchase through ownership to disposal.
Understanding Property Valuation
A valuation provides objective details about a specific property. This estimate must account for factors that affect the property’s value, such as economic and social trends, environmental conditions, and government controls and regulations.
A valuation should consider four elements.
- Demand: Is this property needed? Do potential owners have the financial means to buy it?
- Utility: Is the property able to satisfy a future owner’s needs and desires?
- Scarcity: Are similar investment properties available?
- Transferability: How easy will it be to transfer the ownership rights?
Importance of Property Valuation for Investment Properties
Are you looking to buy a new rental property? How do you know if a potential property aligns with your goals?
Use valuations to assess and analyze potential properties. The estimate will provide insight into your potential return on investment, allowing you to make informed decisions. The valuation affects sales listings, your purchase price, and financing.
There’s a lot to consider when evaluating a potential property, but one question really stands out: What would the potential rents be?
A valuation helps you optimize your potential rental income. Overestimating the value means you could overprice the rent. So, you’ll fall short on your budget, possibly straining your cash flow and discouraging potential tenants. And if you undervalue, you’ll miss out on income.
A sound estimate will also help you avoid problems with financing and insurance coverage during the buying process.
Do you already own rental property? Use your valuation as the foundation for your rent rates, helping you set fair and competitive rates. That’s how the estimate contributes to a transparent and efficient rental market. The value also influences your property taxes and insurance.
And when you’re ready to sell, the valuation helps you determine which property to list and at what price.
Property Valuation Methods
Licensed appraisers or property valuers complete formal assessments. However, you can conduct an informal valuation to assess potential investment properties or to reevaluate rental units you already own. There are three popular methods for valuing real estate.
Method 1: Comparative Market Analysis
The comparative market analysis, also called the market value approach, is based on the sales comparison approach.
With this method, you’ll find three or four properties similar to the one you’re considering. Look for properties of similar size and quality—that will help you justify the value of your potential property. Ideally, these comp properties sold within the last year in a competitive market with typical conditions.
No two properties are exactly alike, so you must add or subtract value to account for changes or different factors like these:
- Age of the property
- Amenities and updates
- Average price per square foot
- Condition of the property
- Date of sale
- Location and neighborhood
- Market conditions at the time of sale
- Sales terms and conditions
Give more consideration to the comps with the least amount of adjustments. Then, once you have your comps ready, use this formula to determine the value of the property you’re considering:
Sale Prices of Comps +/− Adjustments for Differences in Your Property = Property Value
When to Use the Comparative Market Analysis
A comparative market analysis is the best and most popular method for valuing single-family residential property. It accounts for recent comps, then assesses the property’s features and the market activity.
Method 2: Income Capitalization Approach
The income capitalization approach, or income approach, assesses properties expected to generate revenue.
With this method, the property’s estimated potential returns form the basis of the property’s value. That’s why this approach works best when a property’s future income and costs are predictable and steady.
First, you must determine the estimated returns. You need two figures for this formula:
- The net operating income is the value generated by the property minus the operating costs.
- The capitalization rate is the expected rate of return on a property.
Net Operating Income ÷ Capitalization Rate = Property Value
When to Use the Income Capitalization Approach
The income capitalization approach is typically used for valuing investment properties. Start with this method if you’re considering any of these property types:
- Apartments or multifamily housing
- Office units
- Retail space
- Shopping complexes
- Single-family rentals
- Vacation rentals
Method 3: Cost Approach
The cost approach is based on the cost of constructing a similar building plus the cost of land—and it accounts for depreciation. This method asks one question: If the building was destroyed, and you wanted to rebuild it, how much would it cost from start to finish? The cost approach has two methods for determining the answer.
The replacement method uses the cost of modern materials and construction methods. The goal is to calculate the cost of building a similar structure. With this method, the building retains its functionality with updated materials.
The reproduction method considers the cost of building a replica of the original building. Its focus is more on using or duplicating original materials and methods from the era when the building was constructed.
Use this formula for the cost approach valuation:
Construction Cost − Depreciation of Existing Property + Cost of Land = Property Value
When to Use the Cost Approach
The cost approach is particularly effective with properties with more than one building because you’ll have separate estimates for each structure on the property.
This method provides the most accurate valuations for new construction or unique properties with few comps.
How to Get a Property Valuation
Valuing properties yourself can help you narrow down your list of potential investments. But once you have identified your top choices, you may want a professional valuation. An independent, third-party estimate gives you a more accurate review of a property’s true value.
Online Valuations
Start with online tools. Depending on which option you use, you’ll need to provide an address and basic information about the property. Bank of America, Chase, Zillow, and Bankrate all have valuation features. They rely on public records for information on square footage, the number of bedrooms, and lot size to calculate the property’s value.
Just remember that the estimates these tools provide are less accurate since they can’t account for the property’s current condition or recent renovations.
Real Estate Agent Valuations
Real estate agents also help value properties. They know the area and the market conditions, so they can identify comps quickly for a comparative market analysis. Agents can have two appraisal designations: general accredited appraiser or residential accredited appraiser. Use Realtor.com’s search feature to find a designated agent in your area.
Pro Tip: Avoid using the agent associated with the property you’re considering. Your agent’s commission depends on the property’s price, so it’s in their best interest to have a high value and sale price.
Professional Appraisers
Another option is to work with a professional appraiser. The Appraisal Institute is the largest professional association of real estate appraisers in the US. Use their directory to connect with a local, licensed professional appraiser in your area.
Like with real estate agents, there are different specialties for appraisers. The different designations will help you find a property appraiser who is familiar with your industry and area of focus:
- SRA professional designation: Appraisers with experience in analysis and valuation of residential real property.
- SRPA designation: Appraisers with experience in the valuation of commercial, industrial, residential, and other property types.
- MAI designation: Appraisers with experience in valuation and evaluation of commercial, industrial, residential, and other property types. They also advise clients on real estate investment decisions.
Mistakes to Avoid in Property Valuation
Real estate valuation affects every stage of rental property ownership. Use these tips to avoid common estimation errors.
When Purchasing Rental Property
Don’t skip your valuations: In some areas, they’re required for tax assessments. Check with your lawyer or property manager about requirements in your area.
Don’t rely on comps that need lots of adjustments: Find comps that are as similar as possible to your property. It’s ok to go outside your local market if it means the properties are more comparable. Just remember to factor in market differences.
A higher value isn’t always better. Remember, the goal is an accurate valuation of the property. Overvaluation can lead to inflated, unfair rent prices or extended vacancies, while undervaluation means you’ll suffer financial losses.
Once You Own Investment Property
Don’t assume the property value is steady from year to year: Reassess your property’s valuation regularly. The condition of your property and the market changes between tenants, particularly with long-term rentals.
If you keep using an outdated value, over time, your metrics will become skewed. Without an updated valuation, the owner’s equity on your balance sheet will be understated.
Don’t forget to adjust your property insurance: Update your insurance coverage when you reassess your property’s value. If you’re using an outdated value for your investment property, your coverage may not be enough when you make a claim.
How REI Hub Can Help in Property Valuation
REI Hub understands that property values matter to real estate investors. That’s why we make it easy for you to track and update your properties’ values. Start right from our dashboard, where you can view values by property or at the portfolio level.
We also have built-in reporting that goes beyond standard financial statements. Your estimated property values feature in return-based reports, like the portfolio value by property, cap rate, and cash-on-cash reports.
With our performance reports, you can track your net operating income on a monthly and annual basis and monitor your operating expense ratios to ensure the health of your investments.
Plus, our integration with TurboTenant allows you to securely collect rent and track transactions—all without manual entry.
Ready to let REI Hub help you level up your income property accounting? Sign up for a 10-day free trial today!
