How to value real estate investment

There seems to be a lot of confusion about how much real estate investment is really worth. Let’s talk about three common ways people calculate the value of their property.

Choose a price

This is how most homeowners set a price when they are ready to sell. They simply choose a price based on what they want. Sometimes they use other area sales as a guide, but it mostly comes down to the fact that they want $200,000 for it and that’s what they’re asking for. If someone else is willing to pay the price, that’s what it’s worth. Factors like “it’s cute” and “it’s so close to high school” play a role.

Inexperienced investors and agents dealing primarily in single-family residential properties typically treat apartment buildings, office space, and any other type of investment property the same way. They just come up with a price out of thin air, or say, “Well, that ten-unit building across town sold for that much, so this one should be worth that much, too.”

This is a dangerous proposition, as these prices are not based on how well the property operates. If you buy an investment whose price comes out of nowhere, you will almost always end up in a world of pain. Never invest because you “fall in love” with how beautiful a property is. Sure, buy a house that way, but never invest that way.

Gross Rent Multiplier

Many times, the price of investment properties is based on gross income multiplied by some number. That “some number” is called the gross income multiplier.

For example, if a seller can get some compensation for similar type properties that recently sold, you can see what price those properties sold for. If they can identify how much money the properties were bringing in, the seller can take the average and say, “Comparable properties in this area are selling for 3 times their annual gross income.” That produces a gross rent multiplier of 3. Then they take that multiplier and say, “My property brings in $500,000 per year, so it must be worth 1.5 million.”

This is better than just choosing a price, but it’s still flawed. You see, it does not take into account all the necessary operational information, in particular expenses.

Capitalization rates

Cap rates are a third (and even better) way to calculate value. They take into account the actual operation of the property. A cap rate is based on the net operating income (NOI) of a property. NOI is property income minus expenses, and does not count mortgage payments as an expense.

The formula for finding the cap rate is simple:

NOI / Value = Capitalization Rate

Example: Let’s say a property has a net income of $50,000 a year and is selling for $700,000.

50,000 / 700,000 = 0.0714…

.0714 = 7%

So that property was sold with a capitalization rate of 7%.

If you calculate the cap rates for various properties in your area, you can calculate the average cap rate and use it as a guide when you’re looking to buy.

Once you have established a market capitalization rate, you can calculate what the current market value of a property should be. The formula is simple.

Property Value = NOI / Capitalization Rate

Example: The average cap rate in your area is 8%, you have an apartment complex that has a net operating income of $43,200. What can you estimate to be the market value of your property?
43,000 (value) / 0.08 (cap rate) = $537,500

That, of course, doesn’t guarantee that you can actually get that much (or pay that little), but it does show what price your property would sell for if you followed current market trends.

So practice calculating cap rates and prices. This is how the real investor calculates things.