Determining value of real estate is both a science and an art. From the initial analysis through more in depth due diligence, real estate investors are constantly determining the value of properties and searching for properties that are undervalued.
Multifamily properties and single family properties (1-4 units) are valued differently.
Since single family homes can easily be compared to one another, they are valued based on other similar homes. For example, a 3 bedroom 2 bathroom 1800 square feet house can be compared to other similar 3 bedroom two bathroom houses in the area. You can compare apples to apples. This is how the value of single family homes are determined. Typically a licensed appraiser will perform a comparative market analysis, to determine the value of a property.
Multifamily properties, on the other hand, are not valued the same way. Since it’s much harder to compare a 20 unit class C property to a 160 unit class A property, multifamily properties cannot be compared to one another, based on square feet, amenities, etc. Rather, multifamily properties are valued based on the income they produce. The value is derived from two numbers – the Net Operating Income (NOI) and the Capitalization (Cap) Rate. The NOI is simply all of the income minus all of the expenses, excluding the mortgage. The Cap Rate is a measure of return if one paid all cash for the property. Typical cap rates range from 5 – 10% depending on the property type, location, condition, etc.
The value is calculated by dividing the NOI by the Cap Rate. So let’s say you have a property that creates $50,000 of NOI. This property is a C class property, but has been well maintained. The going Cap Rate for this property type in this area is 8%. So we take the $50,000 of NOI divided by 8% to give us a value of $625,000.
These are the differences in how multifamily and single family properties are valued. One with comps, the other with income.
With single family properties, appraisers have a tough job. Unfortunately, sometimes their assessment of a property’s value doesn’t always match the buyer’s or seller’s. However, the bank will only loan based on the appraisal, so that appraiser’s assessment carries a lot of weight. It’s not a perfect system, and can sometime cause deals to fall through.
Investors have their rules of them they like to go by, for example a 1% Rent to Value ratio, or a price per door dollar amount. These are all useful for a quick analysis of a property, but to determine a more accurate value, you need to do a more in depth analysis of the property.
Understanding these basic valuation methods will help you analyze deals, and make good, sound offers.
For a couple a great property calculators, I recommend the BiggerPockets rental calculator for single family properties, and Michael Blanks, Syndicated Deal Analyzer for multifamily properties. Both are linked in the show notes, if you would like to check them out.
Get out there, analyze deals, make offers, buy income producing rental property, and you’ll be well on your way to building wealth and achieving financial freedom.