There’s never been a better time to invest in real estate. People are increasing their incomes by buying up and renting out investment properties all over the globe. Before you can take advantage of real estate investing, however, it’s critical to understand how these properties are valued. Below are four ways to value investment properties.
Sales Comparison Approach
The sales comparison approach (SCA) is simply an estimated comparison of similar residential properties that have sold or rented out in a given area over a particular amount of time. This method is one of the most commonly used methods for valuing real estate.
As an example, if a 2,000-square foot property rents for one dollar/square foot, it’s safe to say that an investor can expect the same return on his investment when he purchases a similar property in that area at that time. Of course, every home has features that make it unique and sometimes hard to quantify, so the SCA is really just a generic measurement and shouldn’t be relied upon as fact.
Capital Asset Pricing Method
The capital asset pricing method (CAPM) takes into consideration the risks associated with investing in real estate. This method helps you decide if it’s worth taking the risk to rent a particular piece of real estate.
When figuring the CAPM, the potential return on investment (taken from the rental income) is compared to other risk-free investments such as real estate investment trusts. If the expected risk-free investment return is more than the expected return on investment from the rental income, it just doesn’t make sense to take the risk on that property.
Used commonly for commercial real estate investing, the income approach details what the potential income of a rental property is in relation to what the initial investment is. Using the annual capitalization rate, the income approach divides the projected yearly income from the rental income by the current value of the property.
For example, if a commercial rental property costs $120,000, and the expected monthly rent is $1200, the expected annual capitalization rate is 12 percent.
The downside to this calculation is that it only takes into consideration one year’s worth of income, and it does not include any additional expenses such as mortgage interest and the like.
The cost approach is typically used to place a value on vacant land. This method tells investors that an investment is only worth what it can reasonably be used for. It is determined by adding the land value and the depreciated value of any improvements.
A good example of the cost approach is if you are an apartment developer looking for land to build condos on. If the land you want to purchase is surrounded by oil fields, and the closest residents live 20 miles away, it makes more sense to not use the land for condominiums, but instead, to use it to expand drilling rights to find more oil. The value of the land is based on its best use.
Real estate investing is a great way to fund a better lifestyle or save for retirement. Understanding how investment properties are valued is the first step in getting your feet wet as an investor.