How To Correctly Value An Investment Property
In this post, we’ll dissect real estate valuations.
What Is a Real Estate Valuation?
Simplistically, a valuation is a measure of how much a specific property (the “subject property”) is worth. Framed differently: at what price is an investor willing to buy the property, and the owner willing to sell?
When you peel back the layers, there are really two types of valuations: a “market valuation” and an “internal valuation” or “personal valuation.”
The market valuation is the broader market’s view on what a property is worth. Each property has only one market valuation. There is a formal process for determining this value, typically completed by a third party such as a licensed appraiser or real estate broker not involved in the transaction. Most lenders rely on a third-party valuation to inform loan amounts.
Internal valuations are more nuanced; they incorporate a wide variety of inputs and vary from investor to investor. While market valuations are largely informed by recent comparable transactions, internal valuations reflect what investors are willing to pay based on a number of factors, especially forecasted investment returns.
The significance of valuations depends on what stage a deal is in its investment lifecycle. Are you looking to buy, or considering selling? All buyer profiles—consumers, individual investors, and institutions—rely on some sort of valuation. It is a best practice to establish an internal view of a property’s value before placing an offer.
Can a property’s valuation and price be different?
In a perfect world, with efficient markets and information-parity, valuation and price would be the same. Economists often base predictions in this so-called “perfect world.” However, real world investors know better. There are times when valuations and the price someone is willing to sell differ widely. This is especially true in illiquid markets like real estate.
As a buyer, you aim to take advantage of pricing discrepancies when your valuation is higher than the price, a phenomenon known as arbitrage. Conversely, as a seller, you want to maximize price, regardless of your valuation.
The Value of a Valuation
Good investors know that valuations should not be driven by emotion or by their perception of a competitor’s or seller’s value. Maintaining discipline can be hard, but is critical to building a durable track record of investments.
A common mistake is discovering one of your assumptions was wrong or that you missed something, and not adjusting your valuation accordingly. For example, if during diligence you discover the roof needs to be replaced, your valuation should immediately adjust to account for the cost. Even if you decide not to replace it during your hold, you should assume that your buyer will include the cost in their valuation, so it will impact you either way.
If your valuation helps you place a winning offer – that’s fantastic; however, if you get beat on a deal, that’s ok. You should feel confident walking away if the valuation you set does not meet the seller’s expectations, or comes up short vs. a competitor’s offer. Instead, use your time and money to find other properties that better fit your strategy and return targets.
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Common Real Estate Valuation Methods
Advanced Valuation Methods
Levered Metrics
Which Valuation Method Is Right For You?
Forecasting Future Valuations
Incorporating Valuation Into Your Investing Strategy
Common Real Estate Valuation Methods
Comparable Property Transactions
Also known as “Sales Comps” or simply “Comps” – this most common valuation method, and is conducted by completing a Comparable Market Analysis (CMA). The objective is to identify the most relevant recent transactions of comparable properties that have similar attributes to the subject property. Those sale prices are used to triangulate a range of present values for the subject property. This can be calculated using a nominal factor, such as the total dollar amount, or with a multiple, such as the Price per Square Foot ($/sqft).
Active Listings
Similarly to Comps, you can look at the listing prices of comparable properties currently for sale. These are not an exact gauge of fair market value, since they have not yet attracted a willing buyer, but they are helpful in another way – these properties are “the competition” for dollars. An investor could choose to buy them instead of the subject property, so staying within a fairly consistent price range is only natural.
Replacement Cost
A different way to look at value is by asking the question: “what would it cost to build the property from scratch today?”
Replacement Cost = Market Value of the Land + Construction Cost of the Improvements
Replacement cost analysis is particularly useful as a confirmatory gut-check. If you acquire a property for $150K that would cost $300K to build today, you are well positioned to compete against newly constructed supply.
The valuation methods listed above can be used to inform what a property is worth in its current condition (As-Is Value, or AIV), and what the property hypothetically could be worth after a contemplated renovation (After Repair Value, or ARV). An investor would select different comparable properties to support each scenario.
Advanced Valuation Methods
The valuation methodologies discussed above are limited to utilizing present or past data. These are helpful, but are only part of the picture. When conducting valuations, investors should factor in predictions of the future.
Sophisticated investors rely on internal valuations informed by forecasting future cash flows. There is no other way to answer the all-important question: “what are my expected returns from this investment?”
Cap Rates
A standardized measure of a rental property’s income potential is a widely-used metric called a Capitalization Rate, or “Cap Rate” for short. There are two primary inputs: i) Net Operating Income, and; ii) Property Value.
Cap Rate = Net Operating Income Property Value
The Net Operating Income (NOI) is the “unlevered” income generated by the property, prior to considering financing costs like interest expense. (Learn more about levered vs. unlevered returns in our previous post)
Net Operating Income = Rental Income – Operating Expenses
To determine Rental Income, you would annualize the in-place monthly rent, or assume the property is leased at current Market Rents. Operating Expenses include the ongoing costs (Insurance, Maintenance, Taxes, HOA Fees, Property Management, etc.).
The higher the Cap Rate, the higher a property’s income potential relative to the purchase price. Using easy numbers, a $100K property being acquired at a 5% Cap Rate would generate $5K per year in NOI. A shortfall to exclusively using Cap Rates is that they ignore appreciation and the eventual sale value, which is often a major contributor to investment returns.
A useful trick for quickly determining how much you are willing to pay for a property can be done by rearranging the cap rate formula to solve for Property Value.
Property Value = Net Operating Income Cap Rate
If you are aiming to acquire properties for a 5% Cap Rate, you would be willing to pay $200K for a property that generated $10K in NOI ($10K 5%). So if buying at a 10% Cap is your fancy, you’d only be willing to pay $100K for the same property ($10K 10%).
Say, for example, Cap Rates in Houston for Class B rentals average 5% and a property you are evaluating can be acquired at a 7% Cap – you might have found a compelling investment opportunity, or there may be a hidden risk you don’t yet know about!
Single family cap rates typically range from 3% – 8% depending on the geographic market and quality of the property. Different markets and property types trade at different Cap Rates, which is a factor of investor demand and perceived risk. The higher the demand or lower the risk, the lower the cap rate – or at least that’s the common wisdom.
In today’s low-interest rate environment – buying properties at low cap rates can be risky for a different reason. When interest rates increase, Cap Rates follow as investors demand a higher return relative to the “risk-free rate.” A change in market cap rates from 4% to 5% is a 25% increase (5% ÷ 4% – 1). The implication of that is a property’s NOI would need to increase by 25% just to maintain its value! That can be hard to do when market rents only increase 2% – 5% per year.
Discounted Cash Flow (DCF)
Moving up the complexity ladder, a DCF valuation incorporates all future cash flows – spanning from the acquisition (cash outflow) to sale proceeds (cash outflow) – and discounts them back using a ‘discount rate’ to arrive at today’s “net present value” (NPV). The discount rate utilized can be a “market” discount rate if the intent is to determine a market valuation, or reflect an investor’s desired return to come up with an internal valuation.
The formula is too complex for cocktail napkin calculations – but can easily be done in Excel by using the “NPV” function.
NPV = CF1 (1+r)1+CF2 (1+r)2+…….+CFn (1+r)n
Where…
CF = Cash Flow for a period
r = discount rate (annualized)
{n} = time period (typically years)
Most individual investors don’t use DCF valuations, however institutional investors use quarterly DCF valuations to adjust their portfolio value for investor reporting, a practice called “marked-to-market.” (See our Institutional Investor blog post to learn more.)
One thing to keep in mind for Cap Rates and standard DCF valuations is that neither contemplates leverage, which as we know, can be a significant factor in generating returns.
Levered Metrics
At the end of the day, all investment decisions boil down to this important question: “what is my expected return from this investment, and is it worth the time, effort and risk relative to my other investment opportunities?”
The only way to truly answer that involves forecasting your return metrics, including leverage when you plan to use it. This practice informs your “maximum valuation” or the highest amount you are willing to pay. If you can acquire the property for below your maximum valuation – you are set up to exceed your return thresholds.
Investors have a menu of return metrics to choose from – the most common ones are listed below. They can all be useful (or not) for different reasons; we’ll get into the details in a future post.
Which Valuation Method Is Right For You?
With all of these standardized valuation methods, why do different investors have different valuations?
There are countless reasons investors attribute different values to the same property; it boils down to the individual nature of internal valuations.
A common factor that leads to a disparity of valuations is that investors’ return expectations differ. For example, if Investor A is targeting a 12% IRR, they are willing to pay more than Investor B, who has a 15% IRR threshold.
Different investors have access to different types of capital. A skilled investor with a strong track record is able to borrow at lower interest rates than a first-time investor. Those with a lower cost of capital can afford to pay more for the same property and earn an equivalent return, all else equal.
Sometimes valuations differ due to “Information Advantage” – one investor simply knows something others don’t. Given the opaque nature of single family real estate, this is common.
Certain investors have unique operating skills or other advantages over competitors. Someone that can generate revenue others can’t, or operate a property more efficiently and with a lower cost structure – can afford to pay more than the average investor. Examples include investors that can self-manage a rental (often improving margins by 6% – 12%), or for brokers who earn a fee for buying and selling the property.
Why Forecasting Future Valuations Is Helpful
Many individual investors only think about valuation during the acquisition. That’s important, but it is best practice to maintain awareness of your valuation during the hold period as well.
Additionally, understanding your valuation helps you pre-determine the “what am I going to sell it for” value. It’s helpful to have this answer in your back pocket, as you never know what opportunities may arise.
A relatively sophisticated strategy employed by the best negotiators is to forecast a likely buyer’s business plan to understand their anticipated returns. If a buyer’s purchase price is so high that it seems impossible for them to make a profit, the likelihood of the transaction hitting a snag is pretty high. On the other hand, if the buyer is standing to make above-market returns, then you can have confidence to hold firm on your pricing if they ask for a discount.
Incorporating Valuation Into Your Investing Strategy
Single family real estate has a unique challenge and opportunity – the number of potential deals is orders of magnitude more than other asset classes. It is not uncommon for a single city to have 75,000 houses transact each year. Compare that to the fact there are only ~6,000 publicly traded companies in the US. With volume potential significantly greater than other asset classes, the transaction opportunities in SFR are endless.
As anyone who’s ever worked in sales will tell you, it is a numbers game. Maximizing the opportunities at the top of a funnel gives you the best chance of success. The number of properties adds up quickly; running valuations can be a full-time job, and then-some. Finding comps for each property is time consuming and unless you have tools to help you be efficient and stay organized, you’ll be spinning your wheels and are prone to make a mistake.
It can be tempting to spend as little time as possible valuing each property before moving to the next one; this leads to human errors and oversights. The worst case scenario is that you overlook something important and make an investment that loses money. Not quite as bad, but still frustrating, is a missed opportunity to make a great investment.
The Backflip Analyzer in the Backflip App allows investors to easily complete a quick, thorough valuation – with multiple methodologies. By simply inputting a subject property’s address, you can calculate the As-Is Value, After-Repair Value, Cap Rate, and determine your expected returns in seconds – all from the palm of your hand.
The interactive deal indicator can be used to quickly understand if a property has strong returns (or not). Dynamic functionality allows you to easily adjust different inputs to determine returns, ideal strategy, and purchase price.
At Backflip, our priority is providing our members with the data, tools and capital they need to create strategic investment plans that help them grow their business. With your goals in mind, we built our Analyzer tool; evaluating prospective investments has never been easier.
