How do you determine the investment value of a property? Well, it’s an art. It’s not like valuing a house in which you are going to live. That would be the homeowner value. When estimating a property’s investment value, there are a variety of real estate valuation methods you can use. In this article, we’ll walk through several techniques and discuss the advantages and disadvantages of each.
Keep in mind that there is no right or wrong valuation method. Successful real estate professionals should understand each system, so they’re able to communicate with many different buyers and many different sellers in many different situations.
A real estate investment property is like a money machine. It has three main parts: income, expenses, and financing. The value of that money machine is determined by how these three parts interact. So, doesn’t it seem logical that the most effective method of valuing a rental property would take into consideration all three parts? With that in mind, let’s look at five valuation methods used in the marketplace and discuss the pros and cons of each.
Enroll in Real Estate Investing: Beyond the Basics to learn about a sixth valuation method—one that allows you to identify the desired rate of return then work backward to calculate the optimal price.
Price per square foot
The first valuation method is “price per square foot.” The formula for price per square foot is the cost of the property divided by the number of square feet. For example, let’s say a $390,000 6-unit apartment building has 3,000 square feet. $390,000 divided by 3,000 equals $130.00 per square foot.
Test question: Would a money machine costing $130.00 per square foot be a good investment? There’s no way to tell without knowing the income, expenses, and financing—which the price per square foot method ignores. Maybe the one good thing we could say about this method is it’s a way to “test the wind” by comparing the price per square foot of several different properties. But, even then, you don’t have enough information to make a wise investment decision.
Price per unit
The formula for the “price per unit” is the cost of the property divided by the number of units (typically apartment units). In our example, it would be $390,000 cost divided by 6 units, which equals $65,000 per unit.
Everything we said about price per square foot can be applied to price per unit. It does not take into account income, expenses, or financing. Again, it might be a way to test the wind, but it’s not very meaningful.
The third method is called “gross multiplier.” The formula is the cost of the property divided by the gross operating income. Let’s say the gross operating income for our 6-unit example is $56,715. Our gross multiplier formula is $390,000 cost divided by $56,715 gross operating income. The result is 6.88.
Unlike the first two methods, the gross multiplier method does take income into account. But what about the other two parts of the money machine: expenses and financing? It doesn’t take either of these into account.
“Capitalization rate” (or “cap rate”) is one of those things you hear all the time in the marketplace. It is expressed as a percentage. The formula for capitalization rate is the net operating income divided by the cost. The 6-unit’s net operating income is $30,065. $30,065 divided by the $390,000 equals 7.7%. That’s a 7.7% cap rate. But what does that mean?
One way of looking at cap rate is that this property is producing 7.7% of its cost in net operating income. Therefore, cap rates can be advantageous when comparing two or more properties. Once you know the cap rate of each property, you can judge which one is producing the highest percentage of net operating income.
Does capitalization rate take into account income? Yes. Expenses? Yes, because we’re using the net operating income. But, here’s a key point: the cap rate does not take into account the financing. The reason is that the cap rate is based on the net operating income, which is what we have before the debt service is paid. Cap rate assumes you pay cash.
Cash on cash
“Cash on cash” is a measure of how much cash flow an investor would be earning measured against the cash that they invest. The formula is cash flow before tax divided by cash invested.
This method focuses on cash flow as the most crucial financial benefit of owning investment real estate. The idea is that, yes, the other three benefits (principal reduction, tax savings, and appreciation) are nice, but cash flow is the most important. In fact, cash on cash is more important than ever today. In the old days, investors were sometimes willing to buy property with a negative cash-on-cash return because they counted on the tax benefits or the appreciation to compensate for the negative cash flow. But now, the tax benefits have been watered down, and appreciation is not a sure thing. Today a property usually has to produce a significant cash-on-cash return to make it worthwhile.
Which valuation method is the strongest?
“Cash on cash” is the strongest of the valuation methods we’ve discussed so far. It takes into account all three parts of the money machine: income, expenses, and financing. Cash on cash enables you to do an apples-to-apples comparison of properties. Many experienced investors have a “target” cash-on-cash rate. If the property will produce cash on cash equal to or greater than their target rate, they buy. If not, they walk away.
Enroll in Real Estate Investing: Beyond the Basics to learn about a sixth valuation method—an even more powerful method that allows you to identify the desired rate of return and then work backward to calculate the optimal price of a rental property.
And remember: There’s no right or wrong method of valuation. No matter which way you use to make your purchase, it’s important to re-evaluate the value of your investment property every year. For more info on why and how to re-evaluate, read: Does Your Rental Property Investment Still Make Sense?
Enroll in Real Estate Investing: Beyond the Basics to get the easy-to-use Investment Property Worksheet—designed to help you quickly and effectively analyze a property.
About the Course Instructor
Tom Lundstedt, CCIM, is known as the funniest investment and tax guy in America. His programs for REALTORS® have entertained and enlightened thousands of audiences from sea to shining sea. He’s a former Major League Baseball player whose striking combination of humor and real-world examples makes powerful subjects spring to life. He’s the author of a series of audio CDs and Study Guides on the subjects of investment real estate and taxation. Visit his website at www.tomlundstedt.com.