Firms often choose one of three common real estate valuation methods for fair valuing their properties. Do you know what they are? If not, you should.
The most common real estate fair valuation methods include the income approach, sales comps, or the bid on value (BOV) method. Most opt for the income approach, which gives you a clear estimate of the specific investment’s value based on actual net operating income and recent sales.
The Income Approach
The income approach involves three crucial steps:
- Projecting Future Net Operating Income: Start by creating a discounted cash flow model to predict the net operating income (NOI) for the next 12 months. NOI, not to be confused with net income, is the linchpin of real estate valuations. It encapsulates the property’s cash flow by considering operating revenues and expenses.
- Determining Market Cap Rates: You must gauge the specific investment’s market cap rates. Cap rates, or “capitalization rates”, are typically calculated as the sum of forward 12 months’ NOI divided by the property’s purchase price or valuation. Cap rates differ greatly by market, property type, vintage, and more. You must research each property’s cap rate and consult third-party data sources for accurate, recent, and property-relevant cap rates.
- Calculating Property Value: Armed with NOI projections and cap rates, you can unravel the property’s true value. Divide the investment’s projected 12 months’ NOI by the market cap rate, and you’ve got the value of the property if it were to sell today.
Sales Comps
If properties sold recently near yours, then you could argue that your property would sell for around the same price. That said, you need to ensure comparability of properties via:
- vintage,
- construction,
- size,
- composition, and
- other reasonable forms of comparison.
Typically, firms will gather as many recent comps (comparable sales) as possible. Then, they will divide each purchase or sale price by the property’s square feet, units, beds, etc.
Next, they will average the purchase price per square foot, units, beds, etc. and then multiply it by your property’s square foot, units, beds, etc. This allows you to calculate your property’s relative value.
Finally, this valuation method is tricky not because of the math, but because many states are what’s called “non-disclosure” states. In these states, parties to a real estate sale are not required to disclose price information. That makes accessing recent sale comps challenging.
BOVs
Another common real estate valuation method is BOVs, or broker opinion of value. I rarely see this method used in isolation to value a property. Normally, you request BOVs to support the sales comp method of valuation or your income approach valuation. That’s because a BOV is exactly what it sounds like: a broker’s opinion of your property’s value. Most brokers will provide you with a higher-than-actual BOV to entice you to sell. As such, it’s not considered as reliable as the other two valuation methods.
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