The Six Economic Principals of Real Estate Valuation

real estate valuationReal estate valuation is a process used by real estate analysts to estimate a single price one would realistically pay to own a particular property.

The method most familiar to real estate professionals, of course, is the comparative market analysis (or CMA).

In this case, real estate valuation involves an estimate of value based upon the sale prices for similar other properties in the local market area.

Namely, the real estate analyst chooses which sales are best to use to infer price of a particular property, identifies price-affecting characteristics that differ between sales and subject property, then estimates the dollar value of those differences to subsequently value the subject based upon those adjusted sale comparisons.

What is not frequently understood, however, concerns the focus of our discussion. That real estate valuation of residential and commercial real estate (i.e., office buildings, apartment buildings, and plots of land) are ultimately based upon the principals of economics.

So in this article, we’ll look at and summarize six of these applied economic principals to give you an idea of the impact they have on valuation of real estate.

1) Anticipation

This is the expectation of future benefits. In other words, real estate investors measure the value of investment real estate based upon the anticipated future income stream generated by the property. So they are more likely to value a property on the income it generates rather than the market value or upon the construction and land costs to replace the property.

This, of course, should not come as a surprise to you who understand real estate investing. That real estate investors most of all buy the cash flows they expect to collect from the investment property.

2) Conformity

This is defined as the need for reasonable similarity and compatibility in a given location. Compatible land uses, for instance, may generate higher values than those with limitations imposed upon the property due to location.

For example, an apartment complex located in a primarily residential area will most likely have more value than one located in a highly industrial area.

3) Supply and Demand

This principal surrounds both the scarcity and demand for the property. Although investment real estate with similar physical and economic characteristics typically sell for similar prices, real estate valuation can be greatly impacted in a market that does not have a reasonable balance between supply and demand.

For example, land in a metropolitan area (where undeveloped land is scarce), would command greater value than land in a rural area (which tends to have large amounts of vacant land). Likewise, an apartment complex selling at a time when there was more than enough supply to meet the rental demand would have less value to a real estate investor than at a time when there was less supply to appropriately meet the demand.

4) Highest and Best Use

This is an important concept that encompasses the highest use and the best use of the property rather than its current use. In other words, when legally possible, appropriately compatible, physically possible, and economically and financially feasible, property valuation can be affected when other (greater advantage) uses for the property are available.

An apartment building that can be converted to condominiums, for instance, or a four-unit property consisting of two side-by-side duplexes on two separate tax lots, can dramatically increase its value.

5) Contribution

This essentially means that the value of an income property can be impacted when it is physically, legally, and economically feasible to contribute more space to the property at a cost equal to, or less than, the marginal revenue. In other words, when value added offsets the costs of making the contribution.

For example, when an office building can be enlarged to add additional rentable office space, or an apartment complex can add more (perhaps even larger) units.

6) Substitution

This is an opportunity cost concept. In other words, a rational real estate investor will not pay more for an investment property than what the next best substitute with similar levels of risk will yield in benefits.

Inflation Rate Calculator, Update 6-22-13

iCalculatoriCalculator, the online real estate calculator solution by ProAPOD Real Estate Investment Software, has updated the inflation rate calculator in accordance with the latest US government CPI data released May, 2013.

iCalculator users can now make annual inflation rate calculations from 1913 through May, 2013 with the inflation rate calculator.

For example, you would discover that $100 spent for goods and services in 1913 would require $2,352.98 in today’s dollars for the same goods and services (an annual inflation rate of 2253.0%). Or that $250 spent in 1985 would require $541.23 (an annual inflation rate of 116.5%). Whatever, because the inflation rate calculator allows you to can pick any year and dollar amount you want. Just fill in the form with your three desired entries.

Update is Free

ProAPOD provides this update absolutely free to current users of iCalculator. Just login as usual and start calculating.

How to Access

  • Login to iCalculator from the ProAPOD website
  • Click “Time Value” from iCalculator’s menu of categories
  • Click “Inflation Rate” in the list of calculators displayed

So You Know

iCalculator includes an array of calculators that enable you to quickly and instantly make dozens of calculations PLUS learn the formulas. Learn more and SAVE 50% by clicking learn more about iCalculator and save 50%.

 

Real Estate Investment Value vs. Market Value

real estate investment value and market value

real estate investment value and market valueWith any real estate investment, value can be derived in any number of ways depending upon the definition of the value being sought.

At the end of the day, though, a real estate investor buys rental property based on the specific value that is important to the investor, and that’s what really matters.

Fair enough. Nonetheless, in this article I want to give you a brief summary of real estate investment value and market value in order for you to understand the distinction between the two types of values as well as what each means to an investor.

Investment Value

To a real estate investor, the investment value is the present worth of future benefits that provide a specified target rate of return at the level of risk that is acceptable to the investor.

This value implicitly involves the investor’s unique tax shelter requirements, availability of equity, capacity to borrow, management strategies, required rate of return, and so on.

In other words, real estate investment value is whatever value the investor ultimately places on the rental property in order for him or her to make an investment decision.

For example, a ten-unit apartment complex with low-interest owner financing and favorable terms might be determined by the investor to have a value of $100,000 per unit, or $1,000,000. Whereas, the identical building located right next door with high-interest and non-favorable financing might not compel the investor to pay anything over $95,000 per unit, or $950,000.

The same idea applies to the investor’s other considerations. Perhaps a higher valuation when the rental property provides a lower risk or better tax shelter or less property management, and vice versa. It all boils down to what the investor is willing to pay.

Market Value

The real estate market value estimate uses the same income approach to value utilized by appraisers and involves a market orientation in which the market is researched to provide typical or average values.

In this case, the value is derived using a capitalization process (i.e., capitalization rate) that converts an income stream into some present value using market-derived data.

In other words, market value is an estimate of what a rental property may be worth based upon the typical average values of similar type rental properties that recently sold in the local market. It has no regard for a real estate investor’s particular investment value.

For example, let’s say that the ten-unit apartment complex we illustrated above generates a verified net operating income of $100,000 and our research shows a market-derived cap rate of 5.0% for similar properties. The market value for the complex would be $2,000,000 ($100,000 / .05 = 2,000,000). So it’s not affected by the fact that the investor is willing to pay $1,000,000.

Rule of Thumb

Clearly, real estate investment value can be vastly different than market value. Therefore, the most prudent thing for real estate investors is to define which type of property valuation is most important and then apply that value to any real estate investment property being sought.

Why Real Estate Investors Use Internal Rate of Return

internal rate of returnInternal Rate of Return (IRR) is one of many returns real estate investors routinely use to measure the profitability of rental property.

In fact, rather than simply relying on an appraisal to determine investment value, real estate investors commonly rely on IRR before making any real estate investment decisions.

In this article, we will consider internal rate of return and why it has become such a popular return for those engaged in real estate investing activity.

Popularity

Time value of money consideration is the most predominate benefit investors derive from IRR. Investing in real estate must also be studied from a time value of money standpoint because the timing of receipts from the investment might be more important than the amount received.

Here’s the idea behind time value.

The longer you have to wait to collect your money the less “present value” it has today – and in a time value of money sense, a dollar in the hand today is preferable to one at the end of the year or five years from now.

The beauty of IRR is that it does account for the length of the anticipated holding period and factors for both the scale of cash flows and their timing. In other words, it considers time value of money and states this relationship between scale and timing in mathematical terms.

So it’s a straightforward way for real estate investors to anticipate their return with time value consideration. And as a result, has become one of the more popular rates of return used by those engaged in real estate investing for their investment decisions.

Method

An investment can be defined as an expected stream of income.

When you make a real estate investment, for instance, you invest cash in order to receive a series of future annual cash flows and a future cash flow reversion (cash you receive when you sell the property).

The challenge for real estate investors is to discover what rate of return the investor’s initial equity makes based upon those periodic future cash flows at the same time it considers the number of time periods (years) under consideration in the holding period.

To do this, the internal rate of return model creates a single discount rate whereby all future cash flows can be discounted until they equal the investor’s initial investment.

Example

Say you’re considering a cash investment of $100,000 to acquire a rental income property that you estimate will produce cash flows of 2000, 2100, and 2200 over three years along with cash proceeds of 120,000 from a sale in the third year.

Schema
  • Year 0 Cash Investment
  • Year 1 Cash Flow
  • Year 2 Cash Flow
  • Year 3 Cash Flow
  • Year 3 Reversion
  • Year 0 $100,000
  • Year 1 $2,000
  • Year 2 $2,100
  • Year 3 $2,200
  • Year 3 $120,000
Result

Based upon the scale and timing of the property’s anticipated future cash flows, you can anticipate that your initial cash investment will yield 8.2410% equal in today’s dollars, not on tomorrow’s dollars.

In other words, the sum total for each of the future cash flows discounted back at 8.2410% equals the amount of the initial cash investment.

So You Know

ProAPOD Real Estate Investment Software provides an INVESTOR 8 and EXECUTIVE 10 solution that each automatically calculate internal rate of return for inclusion in the appropriate reports.

Rental Property Operating Expenses Ratio Rule of Thumb

operating expenses

operating expensesOne day I was called by real estate agent who had just listed a multi-unit apartment complex and told that it had a 7.2% capitalization rate.

In my market, that was a very favorable cap rate for rental income property at that time, so I requested an APOD and called my real estate investor for a heads up.

Upon receipt of the APOD, however, a close examination revealed that the operating expenses ratio computed by the agent was just 13%. Of course, this expense ratio is way too low for typical rental income property, and therefore explains why the agent’s listing indicated such a favorable cap rate.

It was clearly a rookie error. But it could have been avoided if the agent had a general understanding about operating expenses ratio and what they typically are relative to the number of units in the property.

So in this article I want to share a simple rule of thumb about annual operating expense ratios that might help real estate agents just starting to work with real estate investment property to track their numbers in accordance with some level of real estate investing reality.

Operating Expenses Ratio

Operating expense ratio is the ratio of individual operating expenses or (as we refer to in this article) of total operating expenses to the gross operating income (revenue after vacancy and credit loss).

For example, if the total expenses are $35,000 and the gross operating income is $70,000, then the ratio would be 50% (total expenses / gross operating income).

Of course rental property operating expenses need to reflect current and reasonably anticipated expenses required to keep the property in operation and should never be inserted irresponsibly as if one-size-fits-all.

The following is merely a rule of thumb. But it should give you an idea about the ratio you might expect to see the next time you create your real estate analysis.

Rule of thumb
  • 1-4 Units Operating expenses for single-unit, duplex, tri-plex and four-plex units are typically between 25-35% of the property’s gross scheduled income.
  • 5 + Units Operating expenses for larger complexes typically range between 35-45% of gross scheduled income.
Why the difference?

Owners of the smaller units generally shift the cost of water and sewer, trash, and landscaping to the tenant. Whereas, owners of the larger complexes often pay for these charges as a normal operating expense. So this ratio between expenses and rental income will vary.

Why the range?

The costs to operate income property vary from city to city. Real estate taxes, insurance, and utilities, for example, are established by the local market and each can impact a property’s expense ratio upward or downward compared to similar rental properties in other market areas.

Bottom line

If you plan to work with rental income property, you would be best served to a little homework about typical operating expenses ratios used for residential and commercial real estate in the geographic location where you work.

Once you discover a commonly-used range, use it to test the validity of any numbers you run. It helps to know what is realistic, and might spare you from getting overly excited about a faulty number later.

So You Know

All ProAPOD real estate investment software solutions automatically compute a operating expenses ratio as you enter your rental property’s financial data.