Real Estate Investing Course
By Steve Gillman - 2005
Real estate appraisal for rental properties isn't the same
as for single family homes. If you were looking at a 24-unit
building, it would be difficult to find similar ones nearby that
have recently sold. Therefore, a market analysis using comparable
sales isn't normally used.
It is also not ideal to use replacement costs either. How
do you figure replacement cost if there is no land for sale nearby
with proper zoning? This is used as a secondary method, though,
and can tell you if maybe you should be building instead of buying.
Real Estate Appraisal Using Capitalization
Investors buy rental properties for the income. Therefore
it is the income that is used to determine value. The rate of
return expected by investors in a given area gives you the capitalization
rate, and this is what you use to accurately appraise an income
1. Start with the gross income, meaning all rents collected,
forfeited deposits, vending machine money, storage rental income,
etc. Include any money that came in for the year. A seller should
make all this information available to you.
2. Subtract all expenses, but not including loan payments.
If the seller does his own repairs or snow-plowing, estimate
what these expenses will be. Just be sure to subtract all real
and normal expenses.
3. Apply the cap rate to the result. If a building's gross
income is $82,000 per year, and the expenses $30,000, you have
a net before debt-service of $52,000. Now apply the capitalization
rate to this figure.
If the common capitalization rate is .10, for example (ask
a real estate agent), divide the income of $52,000 by .10, and
you get $520,000. This is the realistic value of the building.
If the usual rate is .08, meaning investors in the area expect
an 8% return, the value would be $650,000.
Easy Real Estate Appraisal?
Net income before debt-service, divided by the "cap rate:"
It really is a simple formula. The tough part getting accurate
income figures. Is the seller showing you ALL the normal expenses,
and not exaggerating income? If he stopped repairs for a year,
and is showing "projected" rents, the income figure
could be $15,000 too high. This would mean the building is worth
$187,000 less (.08 cap rate) than your appraisal shows.
Another thing smart investors do when buying, is to separate
out income from vending machines and laundry machines. If these
provide $6,000 of the income, that would add $75,000 to the appraised
value (.08 cap rate). Do the appraisal without this income included,
then add back the replacement cost of the machines (probably
much less than $75,000).
Be careful when using any real estate appraisal method. No
formula is perfect, and all are only as good as the figures you
plug into them. Used wisely, though, real estate appraisal using
capitalization rates is one of the most accurate methods.
Bonus Lesson: Real Estate Appraisal for Single Family Homes
For single family homes, there are two basic methods used
in real estate appraisal. They are replacement cost analysis,
and using comparable sales. Appraisal based on capitalization,
is used for income properties.
In figuring replacement cost the question is: What would it
cost to buy this land and put this house on it? If the land (improved)
would cost $40,000, and the house could be built for $150,000,
the value indicated would be around $190,000 - if the house is
fairly new. If it has used up 10% of its useful life, you can
deduct $15,000 for depreciation (notice you deduct depreciation
only for the house, not the land).
Replacement cost is not really a very useful measurement.
It's difficult to say what the land is worth in a city center
where none is left for sale, for example, and tough to gauge
depreciation. It is used as a secondary method, and for unique
homes that can't be compared easily with others.
The primary method of real estate appraisal used for homes
is a market analysis using comparable sales.
Real Estate Appraisal 101
To get a good idea of what a home should sell for, you need
to compare it to homes that have sold. Find at least three similar
homes in the same area that have sold within the last year, preferably
within the last six months. This information is available in
the county records, or from a real estate agent with access to
the MLS (multiple listing service).
Now the confusing part. You start with the selling price of
each of your comparables. If your subject home has a second bathroom,
and the a comparable doesn't, you add the value of the
bathroom to the sales price of the comparable. If a comparable
home has a blacktop driveway, and the subject home doesn't, you
take the value away.
You are rectifying differences, to see what comparable
homes would have sold for if they were like yours. So
if a comparable sold for $140,000, and a bathroom is worth $15,000
in your area (ask a real estate agent for help with these figures),
you add $15,000 for the bathroom it doesn't have. Then
you subtract, say $4,000, for the paved driveway it does have.
This gives you a comparable sales price of $151,000.
In other words, this is what it would have sold for if
it was like your subject property. You add for
the things it doesn't have that your house does, and
subtract for the things it has that your home doesn't.
It's confusing at first, but it will make sense when you do it
a few times.
You do this with all differences between the subject home
and each comparable. When done, you average the three adjusted
comparable prices. So if the three comparables have adjusted
sales prices of $151,000, $162,000, and $149,000, you add the
three figures and divide by three. The indicated value of the
home is $154,000.
Of course all appraisal is an inexact science. If you can
only find comparables sold over a year ago, you have to estimate
appreciation in the area. If one sold with seller financing,
you have to decide how this affected the price. For all of it's
flaws, however, for single family homes, this is the most accurate
method of real estate appraisal.
Note: If you haven't subscribed to this course, and you want
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