Real Estate Valuation. The very first thing we do when a potential deal comes to Elkhorn Group is run an independent valuation. Some people call it “underwriting the deal”. There are three standard approaches to valuing a piece of investment real estate: comparable sales approach, replacement cost approach, and income approach.
Comparable Sales. This is the easiest way to see property value. You search for recent sales of very similar properties and see what they sold for. Search Redfin, Zillow, Trulia, and LoopNet for recent sales in your target area. Look for properties that as are close to your target property as possible. Mark down the prices of recently closed transactions and the purchase price per sq. ft, per acre, per room, and so on. Multiply that number by your target property’s sq. ft., acreage, number of rooms and voila, your first valuation.
Replacement Cost. This is another easy way to value property. find out the cost per sq ft to build in your area (call a local contractor) and the price per acre to purchase raw land (use the comparable sales method above). Multiply your target property’s square footage by the price to build and add the land value. That is the replacement value for your property. Your insurance company uses this method to determine your home value so you can use them to double check your answer. Now you have two ideas of what the property should be worth.
Income approach. If you’re purchasing cash-flowing real estate, most people use the income approach to value the asset. This is by far the best method and the most complicated. Stay with me here.
CAP RATE - Each asset class (apartments, industrial land, single family homes, mobile home parks, self-storage) has a Cap Rate. The Cap rate is the percentage of the purchase price that the investor would like returned to them each year. This return is in form of Net Operating Income. Cap Rates differ across asset classes based on a number of factors, primarily risk and intensity of management. The higher the risk, the greater the return people are going to want for their money. Hotels are perceived as being more risky than apartment buildings, so investors demand a higher return from a hotel investment and thus, a higher Cap Rate.
Cap Rate (Percent Return) X Purchase Price = Net Operating Income
or, alternatively
Purchase Price = Net Operating Income / Cap Rate
Cap Rate is measured as a percentage, the annual return on investment. Note: The Cap Rate does not take into account your bank loan. Your return on investment will change depending on your financing methods. If you purchase a property for $100,000 that has a NOI of $10,000 per year, you would call that a 10% cap rate (also known as a 10 Cap).
Okay, are you ready for the income valuation? Find the standard Cap Rate for your asset class by calling a local broker and asking her what the Cap Rates are in your area for industrial land, motels, or whatever type of asset you are valuing. Now you have one crucial element of the equation.
DETERMINING NOI - You have the Cap Rate. Once you find the NOI you can determine the maximum purchase price that you can pay for the property. NEVER rely on the numbers that the seller gives you for NOI. They will pad their income and reduce their expenses to make the property look better.
The best way to find NOI is to start with Gross Income. What is the property making each month in revenue? You should be able to find this number. Make sure that this number makes sense. Make sure that you end up with an annual number, and not the monthly number or year to date number.
Now find the standard expense ratio for the asset class. The expense ratio is a percentage of Gross Income that you can reasonably expect to pay in insurance, management, utilities, taxes, accounting, advertising, and so on. This number changes for each asset class but should be somewhere between 30-60% (I know that’s a big range). We usually use a conservative 50% when looking at mobile home parks.
Gross Income - (Gross Income X Expense Ratio) = Net Operating Income
Or, more simply
Gross Income X (1 - Expense Ratio) = Net Operating Income
Take the Gross Income and multiply it by the Expense Ratio. This number represents your estimated annual expenses. Subtract the estimated expenses from the Gross Income to arrive at your Net Operating Income. Divide the NOI by your Cap Rate and there is the valuation! That’s how you find the maximum purchase price you should pay using the income approach.
These are very simple formulas yet it is hard for many people to grasp the Cap Rate. Assuming a stable NOI, the higher the Cap Rate, the lower the purchase price. The higher the Cap Rate, the higher the perceived risk. Capiche?!
Parting Thoughts: Real estate agents and Local Knowledge. The easiest way to make money in real estate is to purchase a property for less than the market value. That’s what we try to do in every single deal.
Call a few real estate agents and tell them about your deal and ask their opinion of the price and the area. Feel free to give them the address if you feel good about their character. You have it under contract (right? if the deal seems good, get it under contract), so you should be safe from people trying to steal your deal. Talk to the corner store owner, neighbors, anyone out on the street. People know a lot about their neighbors :).
On a separate but related note, keep in mind that values of fixed assets should be related to incomes in that area. One of my mentors, Ned Davis, has a market research company and says the following:
It is my view that the proper way to value assets is to relate them to income. Income is the anchor that truly determines the limits for valuation. The average family can afford a home some four times the amount of their income. In 2005-2006 new homes were selling for well over five times median income, and that simply represented the rubber band of valuation as far as it could be stretched. - Ned Davis Research
Thanks for reading. Will