As an Certified Appraiser I can tell you that the most common mistake that many beginning real estate investors make is that they pay too much for property. Fact is overpaying for property is often cited as the number one reason why so many newcomers fail to make it as profitable real estate investors. That’s because most beginning real estate investors are woefully under capitalized, and they don’t have the deep pockets that are needed to subsidize their overpriced real estate investments.
For many neophyte investors, paying too much for their first investment property usually proves to be a very costly and fatal mistake, and marks the beginning of the end of their foray into real estate. That’s why it’s imperative that you learn how to accurately estimate the current market value of potential investment properties! As far as I’m concerned, it’s the single most important aspect of the entire real estate investment business!
A Fast $50,000 Profit for Knowing the Value of a Condemned House
I once bought a real estate option on a filthy, neglected, run-down, but structurally sound house in a neighborhood-in-transition within Los Angeles, California, that had been condemned for building, safety, health and fire code violations. This place looked like something right out of downtown Baghdad, Iraq! It had what code enforcement inspectors commonly refer to as accumulations of every type of debris, garbage and junk known to mankind! The property’s owner lived in Westerville, Ohio, and wanted the steady stream of threatening letters from the Winter Park Code Enforcement Board to stop.
I had done my homework, and knew the property was worth at least $450,000 after it was cleaned up. I ended up paying $2500 for a six month option to purchase the house for $365,000. It cost me $10,000 to have all of the accumulations removed from the property, and the house, driveway and walkways pressure washed. Three weeks later, I sold my real estate option agreement for a $65,000 profit! This never would have happened if I had been clueless about how to estimate property values. Since I had an accurate estimate as to how much the property was worth in its current condition, I was able to negotiate a below market purchase price that was based on the property’s filthy, neglected, run-down non-marketable condition, and not on how much it might have been worth after it had been cleaned up.
No Kelly Blue Book for Real Estate Investors to Look Up Property Values
Sadly, there’s no Kelly Blue Book equivalent for real estate investors to lookup used property prices in, so you’re going to have to learn for yourself how to estimate the current market value of potential investment properties. However, thanks to computers and the Internet, in most real estate markets it’s not that difficult to get a rough estimate of a property’s current market value. This is especially true for real estate investors located in counties where all property ownership, sale and tax assessment records are available online.
The Definition of Market Value
The Appraisal Foundation’s Uniform Standards of Professional Appraisal Practice, defines market value as: “The most probable price a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the sale price isn’t affected by undue stimulus.”
The Difference Between Assessed Value and Appraised Value
The difference between a property’s tax-assessed value and its appraised value is as follows:
1. Tax Assessed Value: Tax-assessed value is the value established by the local taxing authority for a parcel of land and the improvements placed upon the land for property tax purposes. For example, in Florida, owner-occupied single-family houses are generally assessed at around seventy percent of their fair market value by county property appraisers.
2. Appraised Value: Appraised value is the value estimate given to a property by a licensed property appraiser using accepted appraisal methods for the type of property being appraised. For example, the accepted appraisal method to accurately estimate the fair market value for an owner-occupied single-family house is the comparison sales method where a property’s value is based on the recent sale of comparable properties within the same area.
The Three Common Methods Used to Estimate Property Values
The three most common methods used by property appraisers to estimate property values are the:
1. Comparison Sales Method: The comparison sales method bases a property’s value on the recent sale prices of properties that are within the same area and comparable in size, quality, amenities and features.
2. Income Method: The income method is used to estimate the value of an income producing property based on the net income the property produces.
3. Replacement Cost Method: The replacement cost method is based on what it would cost to replace the improvements on property using similar construction materials and construction methods.
The Comparison Sales Method of Estimating a Property’s Value
The comparison sales method of estimating a property’s value is based on the recent sale prices of properties within the same area that are comparable in size, amenities and features. In order to be accurate, sale price adjustments must be made for comparable properties that have been sold at unrealistically low prices or on overly favorable financial terms not readily available to the buying public.
The Income Method of Estimating a Property’s Value
The income method is used to estimate the value of an income producing property based on the net income the property produces. Under the income method value is calculated using a:
1. Capitalization Rate. The capitalization rate, or cap rate, is calculated by dividing a property’s annual net operating income by its purchase price.
2. Gross Rent Multiplier. The gross rent multiplier, or GRM, is calculated by dividing the purchase price by the property’s monthly gross operating income.
Watch Out for Owners Using Fuzzy Math
A word to the wise: when you read a property’s income and expense statement, you should always go under the assumption that the owner is probably practicing fuzzy math by fudging on the numbers, and telling little white lies to back them up. Also, use a monthly income and expense analysis worksheet like the sample copy below, to cross-check everything that’s listed on a property’s income and expense statement in order to reconcile the statement with receipts and tax returns against what’s shown on:
1. Schedule E (Supplemental Income and Loss) of the owner’s latest federal income tax return.
2. The property’s latest annual tax assessment income and expense statement on file at the county property appraiser or assessor’s office.
3. All of the rental agreements for the past year.
4. Water, sewage, solid waste, gas and electric bills for the past year.
5. Repair and capital improvement bills for the past year.
The Replacement Cost Method of Estimating a Property’s Value
The replacement cost method of estimating a property’s value is based on the cost of replacing the improvements on the property minus the cost of the land to estimate a property’s value. Replacement costs are calculated on a per square foot basis by dividing the total number of square feet in the building by the per square foot construction cost. For example, a two thousand square foot convenience store that cost $375,000 to build would have a replacement cost of $187.50 per square foot, $375,000 divided by 2000.
How to Get Free Building Replacement Cost Estimates
You can usually get a free building replacement cost estimate by calling a local independent insurance broker who represents insurers that specialize in providing property and casualty insurance coverage for residential and commercial buildings. When you call a broker, tell them that you want a replacement cost quote. Property replacement costs are calculated by using a replacement cost formula that’s based on the property’s geographical location and its:
1. Street address.
3. Type of construction.
4. Number of stories.
5. Type of roof.
6. Current use.
7. Heating and cooling system.
8. Square footage.
Use the Eight-Step Approach to Estimate a Property’s Current Market Value
Use the following eight-step approach and the current value worksheet on the following page to get a rough estimate of a potential investment property’s current market value:
Step # 1: Log onto your county’s property appraiser or assessor’s Web site to obtain the tax assessed value of the property under consideration.
Step # 2: Search your county’s property tax rolls for recent sales of three to five properties that are comparable in size, amenities and features, and located within two miles of the property under consideration.
Step # 3: Carefully analyze any comparable properties that you find, and make sale price adjustments for differences in amenities, special features and the property’s physical condition.
Step # 4: Verify the income and expenses that are listed on the income and expense statement of the property under consideration.
Step # 5: Analyze the property’s income and expenses for the past twelve months to estimate its net operating income potential.
Step # 6: Calculate the property’s capitalization rate by dividing its potential operating income by the estimated value that you derived from analyzing recent sales of comparable properties in step number three.
Step #7: Estimate the property’s value by multiplying its net operating income by the capitalization rate you came up with for the property.
Step # 8: Calculate the cost of replacing the improvements on the property using the same building materials and method of construction.