Powerful Real Estate Valuation Methods
Real estate is an art. From finding your listings to closing a deal, everything needs to have an artistic touch to it. When it comes to property valuation, things can get tricky. Before looking at ways to access value of an investment one must keep in mind that all the available methods have been tried and tested and their use is subjective to people and people only. A real estate investment property is like a money machine. It revolves around three main parts- income, expense and financing. Keeping all these in mind, let’s look into the different methods that we can use to determine right value for a property. A real estate investment property is like a money machine. It has three main parts: income, expenses, and finanacing. 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.
Different Real Estate Valuation methods
1. Price per square foot
This very basic method of real estate valuation is “price per square foot.” The formula for price per square foot is:
- Price per square foot= (cost of property/ number of square feet)
This method is generally used to test and estimate a very basic value of the property. It never involves any variables of finances, condition and location etc.
2. Price per unit
The formula for the “price per unit” is:
- Price per unit= (cost of the property/ the number of units)
This method is almost same as the price per square foot method. It does not account for finance, expenses, income or any other factors.
3. Gross multiplier
The third method for real estate valuation is called “gross multiplier.” The formula is:
- Gross multiplier= (cost of the property/ gross operating income)
Through this formula is said to include the income factor into account but leaves away expense and financing. It can be used in places where you only want to get raw idea of how much income you will be generating in a particular deal.
Capitalization rate
“Capitalization rate” (or “cap rate”) is one commonly heard term. This rate is expressed as a percentage. The formula for cap rate includes net operating income which is expressed as:
- NOI= (Optimal buying price *Cap rate)
Moving further the cap rate can be calculated using the following formula;
- Cap rate= (NOI/ Optimal buying price)
Cap rate is used when there needs to be a comparison between two properties’ investment potential. This rate takes income and expense in account but the net financing is missing. It is based on the assumption that cash is paid for the transaction, which does not hold true in the world of real estate more often.
Cash on cash
This formula is focused on the cash follow. This price determining methods is “cash on cash” valuation, which is a widely used method. They set their “target” for cash on cash rate to achieve, which they want out of their investments. If the property they are going to buy will give them money equal to or above this target (when sold), they immediately latch onto that deal. Many believe this system to be terrific and one can make the cash on cash rate work backward to figure the ideal price. The formula is:
- cash on cash=cash flow before tax/cash invested.
It accounts for principal reduction, tax savings and appreciation as well cash flow.
Which real estate valuation method is the strongest?
“Cash on cash” is the strongest of the real estate valuation methods we’ve discussed so far. It takes into account all the three parts of a proper real estate valuation: income, expenses, and financing.