Appraisal

Real Estate Investing Course

By Steve Gillman - 2005

Real estate appraisal for rental properties isn't the same as for single family homes. If you were looking at a 24-unit building, it would be difficult to find similar ones nearby that have recently sold. Therefore, a market analysis using comparable sales isn't normally used.

It is also not ideal to use replacement costs either. How do you figure replacement cost if there is no land for sale nearby with proper zoning? This is used as a secondary method, though, and can tell you if maybe you should be building instead of buying.

Real Estate Appraisal Using Capitalization

Investors buy rental properties for the income. Therefore it is the income that is used to determine value. The rate of return expected by investors in a given area gives you the capitalization rate, and this is what you use to accurately appraise an income property.

1. Start with the gross income, meaning all rents collected, forfeited deposits, vending machine money, storage rental income, etc. Include any money that came in for the year. A seller should make all this information available to you.

2. Subtract all expenses, but not including loan payments. If the seller does his own repairs or snow-plowing, estimate what these expenses will be. Just be sure to subtract all real and normal expenses.

3. Apply the cap rate to the result. If a building's gross income is $82,000 per year, and the expenses $30,000, you have a net before debt-service of $52,000. Now apply the capitalization rate to this figure.

If the common capitalization rate is .10, for example (ask a real estate agent), divide the income of $52,000 by .10, and you get $520,000. This is the realistic value of the building. If the usual rate is .08, meaning investors in the area expect an 8% return, the value would be $650,000.

Easy Real Estate Appraisal?

Net income before debt-service, divided by the "cap rate:" It really is a simple formula. The tough part getting accurate income figures. Is the seller showing you ALL the normal expenses, and not exaggerating income? If he stopped repairs for a year, and is showing "projected" rents, the income figure could be $15,000 too high. This would mean the building is worth $187,000 less (.08 cap rate) than your appraisal shows.

Another thing smart investors do when buying, is to separate out income from vending machines and laundry machines. If these provide $6,000 of the income, that would add $75,000 to the appraised value (.08 cap rate). Do the appraisal without this income included, then add back the replacement cost of the machines (probably much less than $75,000).

Be careful when using any real estate appraisal method. No formula is perfect, and all are only as good as the figures you plug into them. Used wisely, though, real estate appraisal using capitalization rates is one of the most accurate methods.

Bonus Lesson: Real Estate Appraisal for Single Family Homes

For single family homes, there are two basic methods used in real estate appraisal. They are replacement cost analysis, and using comparable sales. Appraisal based on capitalization, is used for income properties.

In figuring replacement cost the question is: What would it cost to buy this land and put this house on it? If the land (improved) would cost $40,000, and the house could be built for $150,000, the value indicated would be around $190,000 - if the house is fairly new. If it has used up 10% of its useful life, you can deduct $15,000 for depreciation (notice you deduct depreciation only for the house, not the land).

Replacement cost is not really a very useful measurement. It's difficult to say what the land is worth in a city center where none is left for sale, for example, and tough to gauge depreciation. It is used as a secondary method, and for unique homes that can't be compared easily with others.

The primary method of real estate appraisal used for homes is a market analysis using comparable sales.

Real Estate Appraisal 101

To get a good idea of what a home should sell for, you need to compare it to homes that have sold. Find at least three similar homes in the same area that have sold within the last year, preferably within the last six months. This information is available in the county records, or from a real estate agent with access to the MLS (multiple listing service).

Now the confusing part. You start with the selling price of each of your comparables. If your subject home has a second bathroom, and the a comparable doesn't, you add the value of the bathroom to the sales price of the comparable. If a comparable home has a blacktop driveway, and the subject home doesn't, you take the value away.

You are rectifying differences, to see what comparable homes would have sold for if they were like yours. So if a comparable sold for $140,000, and a bathroom is worth $15,000 in your area (ask a real estate agent for help with these figures), you add $15,000 for the bathroom it doesn't have. Then you subtract, say $4,000, for the paved driveway it does have. This gives you a comparable sales price of $151,000.

In other words, this is what it would have sold for if it was like your subject property. You add for the things it doesn't have that your house does, and subtract for the things it has that your home doesn't. It's confusing at first, but it will make sense when you do it a few times.

You do this with all differences between the subject home and each comparable. When done, you average the three adjusted comparable prices. So if the three comparables have adjusted sales prices of $151,000, $162,000, and $149,000, you add the three figures and divide by three. The indicated value of the home is $154,000.

Of course all appraisal is an inexact science. If you can only find comparables sold over a year ago, you have to estimate appreciation in the area. If one sold with seller financing, you have to decide how this affected the price. For all of it's flaws, however, for single family homes, this is the most accurate method of real estate appraisal.

Steve

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