Assessing an apartment’s value is no simple matter. Factor in that a property has a value at time of sale, but it also has a proforma value. A proforma value is based on the projected net operating income after making some improvements to the property. This requires a strong ability in being able to identify the opportunities to add value on the property. Creating value doesn’t just happen by implementing a strategy that produces more income, it can also result from implementing a strategy that reduces expenses. It also boils down to the tricky question of how much a buyer is willing to pay for the apartment. Below are the three most common approaches for property valuation.
Income Approach
This valuation method is based on the amount of income an investor can expect to derive from a particular property. The main idea behind the income approach is to calculate the current value of a real estate property based on the net operating income it generates divided by the market’s capitalization rate. That projected income could also be derived in part from a comparison of other similar local properties, as well as from an expected decrease in maintenance costs.
The equation for the property value is:
Current Value = Net Operating Income (NOI) / Cap Rate
Say a property generates $50,000 net operating income, and is in a market with a 5% capitalization rate. The value of the property is 50,000 / 0.05 = $1,000,000.
Sales Comparison Approach
For this approach, one must first identify comparable sales, and then compare comparables to the subject and make adjustments to comparables. Property characteristics must be similar for this to be accurate; things like year built, unit mix, and class.
This method is also known as “market approach” and it heavily relies on recent sales data for comparable properties or other recently sold properties in the area with similar characteristics. In addition, to be able to use this method, the market must be active – the more recent sales, the better. Otherwise, sales prices lack currency and liability. Lastly, the need to weigh values indicated by adjusted comparables for the final value estimate of the subject.
Replacement Cost
This approach considers the cost to rebuild the structure from scratch combining both the current land value as well as construction material and other costs associated with the replacement of the existing structure.
This approach is considered most reliable when used on newer structures and less reliable for older properties. It is often the only reliable approach when looking at relatively unique or specialized improvements, or when upgraded structures have added a substantial value to the underlying land.
In Closing:
There is no wrong way to determine the value of a rental property. Most serious investors look at components from all of these valuation methods before making huge investment decisions about rental properties. Learning these 3 basic methods is a step in the right direction to getting into the real estate investment game. These approaches will give you more concrete figures to work on when evaluating the value of your rental properties.
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