Technically speaking, a property’s value is defined as the present worth of future benefits arising from the ownership of the property. Unlike many consumer goods that are quickly used, the benefits of real property are generally realized over a long period of time. Therefore, an estimate of a property’s value must take into consideration economic and social trends, as well as governmental controls or regulations and environmental conditions that may influence the four elements of value:
- Demand: the desire or need for ownership supported by the financial means to satisfy the desire
- Utility: the ability to satisfy future owners’ desires and needs
- Scarcity: the finite supply of competing properties
- Transferability: the ease with which ownership rights are transferred.
Why Should You Value Rental Property?
Unlike corporate stocks that are traded on a daily basis and are similar, real estate transactions take place less frequently and every property has unique features. This makes determining property value more difficult. Therefore, knowing the value of a rental property is very essential during real estate transactions.
Property valuation helps you determine the right price to offer and avoid overpaying. It also helps you identify and take advantage of investment properties that are below market value. For instance, a distressed seller who needs to sell the property as fast as possible is likely to sell it at a discount.
So, how do you estimate a rental property’s value? Well, there is no one way to do it. Here are the most common ways to value real estate.
Value Versus Cost and Price
Value is not necessarily equal to cost or price. Cost refers to actual expenditures – on materials, for example, or labor. Price, on the other hand, is the amount that someone pays for something. While cost and price can affect value, they do not determine value. The sales price of a house might be $150,000, but the value could be significantly higher or lower. For instance, if a new owner finds a serious flaw in the house, such as a faulty foundation, the value of the house could be lower than the price.
Market Value
An appraisal is an opinion or estimate regarding the value of a particular property as of a specific date. Appraisal reports are used by businesses, government agencies, individuals, investors, and mortgage companies when making decisions regarding real estate transactions. The goal of an appraisal is to determine a property’s market value – the most probable price that the property will bring in a competitive and open market.
Market price, the price at which property actually sells, may not always represent the market value. For example, if a seller is under duress because of the threat of foreclosure, or if a private sale is held, the property may sell below its market value.
Appraisal Methods
An accurate appraisal depends on the methodical collection of data. Specific data, covering details regarding the particular property, and general data, pertaining to the nation, region, city, and neighborhood wherein the property is located, are collected and analyzed to arrive at a value. Appraisals use three basic approaches to determine a property’s value.
Unlike a valuation, surveys are designed to provide purchasers with information on the condition of a property, this is to assist with the decision of whether to purchase the property or not. It will also inform them of issues within the property that need attention.
The level of both the inspection and reporting for a survey are more detailed than for a valuation. However, the level of inspection and reporting will vary dependant on the scope of the survey product chosen. Details on the scope of the survey will be included in the Terms of Engagement.
Gross Income Multipliers
The gross income multiplier (GIM) method can be used to appraise other properties that are typically not purchased as income properties but that could be rented, such as one- and two-family homes. The GRM method relates the sales price of a property to its expected rental income. (For related reading, see “4 Ways to Value a Real Estate Rental Property”)
For residential properties, the gross monthly income is typically used; for commercial and industrial properties, the gross annual income would be used. The gross income multiplier method can be calculated as follows:
Sales Price ÷ Rental Income = Gross Income Multiplier
Recent sales and rental data from at least three similar properties can be used to establish an accurate GIM. The GIM can then be applied to the estimated fair market rental of the subject property to determine its market value, which can be calculated as follows:
Rental Income x GIM = Estimated Market Value
The Bottom Line
Accurate real estate valuation is important to mortgage lenders, investors, insurers and buyers, and sellers of real property. While appraisals are generally performed by skilled professionals, anyone involved in a real transaction can benefit from gaining a basic understanding of the different methods of real estate valuation.
