There seems to be a lot of confusion about how much investment real estate is really worth. Let’s talk about three common ways people figure the worth of their property.
Pick a Price
This is how most home owners establish a price when the are ready to sell. They simply pick a price based on what they want. Sometimes, they use other area sales as a guide, but mostly it boils down to the fact that they want $200,000 for it and so that’s what they’re asking. 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 the junior high” play a big part.
Inexperienced investors and agents that primarily deal with single family residential properties usually treat apartment buildings, office space, and any other investment-type property in the same way. They just pull 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 into an investment whose price is pulled out of thin air, you are almost always going to end up in a world of hurt. Never invest because you “fall in love” with how cute a property is. Sure, buy a house that way, but never invest that way.
Gross Rent Multiplier
Many times, the price of investment property is based on the gross income times some number. That “some number” is called the gross rent multiplier.
For example, if a seller can get some comps from similar type properties that were recently sold, they can see what those properties sold for. If they can identify how much money the properties were taking in, the seller can take the average and say, “In this area, comparable properties are selling for 3 times their yearly gross income.” That produces a gross rent multiplier of 3. They then take that multiplier and say, “My property takes in $500,000 per year, so it must be worth 1.5 million.”
This is better than just picking a price, but it is still flawed. You see, it doesn’t take into account all of the necessary operating information, notably expenses.
Cap rates are a third (and even better) way to figure the 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. The NOI is the property income minus expenses, and you don’t count mortgage payments as an expense.
The formula for finding the cap rate is simple:
NOI / Value = Cap rate
Example: Let’s say that a property has a net income of $50,000 a year, and it is sold for $700,000.
50,000 / 700,000 = .0714…
.0714 = 7%
So that property was sold with a 7% cap rate.
If you figure out the cap rates for several properties in your area, you can figure out the average cap rate, and use it as a guide when you are looking to buy.
Once you have established a market cap rate, you can figure what the current market value of a property should be. The formula is simple.
Property Value = NOI / Cap 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 the market value of your property to be?
43,000 (value) / .08 (cap rate) = $537,500
That of course doesn’t guarantee that you can actually get that much (or pay that little), but it it does show what your property would sell for if it followed you current market trends.
So go practice figuring cap rates and prices. It’s how the real investor figures things.