With 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.
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.
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.