Three Methods to Appraise Real Estate Properties

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There are mainly three methods to appraise real estate properties which every real estate investor should utilize. These three methods include the sales comparison approach, the cost approach, and the income capitalization approach. There are pros and cons to each method which are discussed below.

 Sales Comparison Approach – Three Methods to Appraise Real Estate Properties

 

The first of the three methods to appraise real estate properties and also the most used method to valuing a real estate property is the sales comparison approach. This approach utilizes recently sold comparable properties (comps) to arrive at a valuation. Sales comparison approach valuations will have to be adjusted for any differences between the property and the comparables. These adjustments will vary per location. A few examples which an investor may need to make adjustments for are size, structure, amenities, homeowner association (HOA) fees, location, etc.

When using a real estate agent, most brokerages have software which can supply a list of comparables utilizing the Multiple Listing Services (MLS). Be wary of what the real estate agent provides as they usually aren’t certified appraisers and may be bias as they only receive a commission upon the buyer purchasing the property. Do your own research. If the house is located in a neighborhood which most houses are similar, find a similar house and research county records to find out what it sold for.  Be sure to use multiple comparables and make sure all comparables are arm’s length transactions. Zillow is a good tool to use to begin your search of recently sold properties.

Cost Approach – Three Methods to Appraise Real Estate Properties

 

The cost approach to appraising a real estate property is useful when the property is somewhat abnormal (churches, schools, hospitals, etc.). This method assumes an investor should not pay more for a property than the cost of the land plus the cost to rebuild the property, less any depreciation. When the property is new, the cost approach produces the most accurate valuation of a property in comparison with other methods.

Cost of Land + Cost to Build Equivalent Property – Depreciation = Cost Approach Valuation

The critical issue an investor will come across when utilizing the cost approach method to valuate a property is determining the cost basis. Contractors’ bids can vary significantly and the associated prices which accompany these bids can change throughout the project as unforeseen circumstances arise. This begs the question, is the cost an investor is attempting to calculate for the exact same building or one which is functionally equivalent. For instance, if there is a single story 10,000 square foot manufacturing plant located in San Francisco and an investor or appraiser is using the cost approach, can he or she utilize the cost for a two story 10,000 square foot warehouse as a comparable due to land being so scarce.

 

Income Capitalization Approach – Three Methods to Appraise Real Estate Properties

 

The last of the three methods to appraise real estate properties is the income capitalization approach. The income capitalization approach to valuing a property is used for income producing properties such as apartment buildings or warehouses. This approach using a capitalization rate to arrive at a valuation of a property.

First,  the investor must search comparable sales and produce a market capitalization rate for these comparable properties. Capitalization rate is calculated using the net income of a property divided by the original cost to purchase. After calculating the capitalization rate, one can take the net operating income of the property and divided it by the determined capitalization rate. This will allow the investor to arrive at the income capitalization approach valuation

NOI/Capitalization Rate = Income Capitalization Approach Valuation

There are many factors to consider when calculating the capitalization rate. A few examples of these factors include:

• Are the comparable properties made up of higher quality tenants?
• How accurate do you believe your expenses and income calculations are?
• Will the property need significant updates in the near future?
• Do all of the tenants work in the same industry which could make them prone to being evicted if the industry suffers (e.g. blue collared construction workers)?

The Income Capitalization Approach is probably the most in depth valuation approach with the greatest uncertainty. There are many assumptions. It is imperative to do thorough research on the numbers which supply this calculation.

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