The Real Value
Our Most Asked FAQ
How are you determing value in today’s market?
How do appraisers determine value in today’s market? They take a map of the area and three darts, put on a blindfold and throw darts!
In all seriousness, this is the question we get asked the most. Unfortunately, putting a value on investment real estate these days is a challenge to say the least. And everybody’s having difficulty valuing property; from Realtors, appraisers, lending institutions, to investors. It’s such a problem most lenders are requiring two appraisals for every loan they underwrite.
Why all the problems?
Here’s the first thing you need to remember, values are nothing more than one person’s opinion. If we hired five appraisers to appraise one single family investment property we'd end up with five different values when finished, because values are subjective. Some appraisers will compare like property with like property. Meaning if the sale of an investment home is a traditional third party sale (not a distressed sale, bank owned, short sale, etc.) they will only use traditional third party sales as comparisons. Some appraisers disagree with that method and believe all sales in the neighborhood should be considered a comparison. (This of course assumes that all the property features are similar; square footage, age of the investment home, construction, bedroom, bathrooms, etc.)
So who’s right? Both – it’s their opinion of value!
So what do we do?
Unfortunately, there’s no easy answer. Today no one method is the end all to be all. What one investor uses may work for them while another investor may have a completely different system. Both may work!
At Wholesale Homes we’ve moved away from the traditional comparative market analysis (CMA) as our primary method of valuing property. It’s too subjective in a turbulent market. Our focus has turned (as well as many other investors) to capitalization rates or cap rates for short.
Actually we are not real concerned about values at this time because we are buying at 2001 prices. (as of 11/2012) . Get an annual return better than obtained by banks, IRA's, 401K's, Money Market Accounts, etc. and your a big winner, because buying at the bottom of the market can only lead to increased value. In fact Phoenix is in "SLINGSHOT RECOVERY" . Priced moving up for 8 straight months, over 25% increase in value in 2012 alone and we are still buying a 2001 prices. Get the better cash flow return and then rapidly growing appreciation over the next 3-5 years and you have mother lode investment.
What are cap rates?
First of all valuing proeprty using cap rates is not a new method. It’s been around for decades and is calculated using the Income Approach. Most investors may not be familiar with the term because it typically applies to commercial real estate. However, using the Income Approach to determine a cap rate on any income producing real estate is beneficial because the fundamentals don’t change!
The cap rate represents the return an investor receives on investment real estate. No different than calucluating a return on a mutual fund. Cap rates are expressed as a percentage and can be calculated by taking the property’s annual gross revenue, minus the property’s annual expenses to get the Net Operating Income (NOI). Then divide the NOI by the total purchase price. (Expenses do not include debt service.)
How do you calculate cap rates?
The easiest way to show how to calculate cap rates is by example. Let’s say an investor wants to determine if $87,000 for a particular investment home is a good price or not. We first calculate the annual gross revenue and deduct the annual expenses. In our example we’ll say that rents are $950 a month and expenses are 35% of our gross income. (Expenses includes everything except the monthly mortgage payments; for example estimated vacancy, management fees, property taxes, property insurance, maintenance, etc.) When dealing with an actual property we would determine the actual expenses in order to get an accurate expense figure. Through the years experience has taught us that 35% is a good “back of the envelope” calculation. (If it's an older investment with deferred maintenance bump the expense factor to 40%.) Here’s how the calculation works:
Annual Income ($950/month * 12 months) $11,400
Annual Expenses (35% of annual income) 3,990
Net Operating Income (NOI) $7,410
Now that we have our NOI we can complete our calculations to determine what our cap rate is:
Purchase Price 87,000
Cap Rate (NOI / Purchase Price) 8.5%
In our example an investor would receive an 8.5% return on their investment. Considering most investments are paying around 2.5% – 5%, 8.5% is looking pretty good and justifies paying $87,000 for this investment home. Don’t forget, with investment real estate there's also the benefit of appreciation (the value the asset increases over time) and depreciation (the paper loss the US Government gives investors) which are not factored in to the cap rate which makes the return on investment even better!
What if you want better than an 8.5% cap rate?
First of all let’s be clear, 8.5% is an excellent return on investment! Look at your other investments if you have any doubts. And after adding appreciation and depreciation, you’re over 9%! But maybe you want better, let’s say you want a 9% cap rate. All you have to do is work the formula backwards to determine the purchase price you’re willing to pay in order to achieve a 9% cap rate. Here’s the calculation using the same example from above:
Cap Rate (Desired Rate) 9.0%
Net Operating Income (NOI) $7,410
Purchase Price (NOI/cap rate) $82,333
In order to achieve a desired cap rate of 9%, the purchase price cannot exceed $82,333. It’s important to realize that cap rate and purchase price have an inverse relationship. The higher the price the lower the cap rate thereby lowering your return on investment. The lower the price the higher the cap rate thereby increasing your return on investment.
Now that you understand cap rates you can see why investors are using them to calculate the value of residential investment real estate. The fundamentals don’t change and gives the investor an exact calculation as to their return on investment. (Fundamentals refer to the income, expenses, price, etc. – While the numbers may change, the formula is constant.)
Eventually the market will stabilize and comparative market analysis (CMA) will be an effective valuation tool again. In the meantime, try using cap rate valuation. You’ll be surprised as to how quickly, easily and most important, successfully you’ll be able to determine a property’s true value as an investor!