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Real Estate Investment Software Blog

When you invest in real estate, you’ll work with appraisers who will typically rely on three techniques to value income-producing properties. It would be helpful as a real estate investor for you to understand these property valuation techniques.

1. Cost Approach To apply the cost approach, you calculate how much it would cost to build a subject property at today’s prices, subtract accrued depreciation, and then add the depreciated cost figure to the current value of the lot.
2. Comparable Sales Approach To apply the comparable sales approach, you compare a subject property with other similar income properties that have recently sold. Then you adjust the prices for each positive or negative feature of the comps relative to the subject property.
3. Income Approach To apply the income approach, investors estimates the rents an investment property can be expected to produce and then convert those rents (income stream) into a capital (market) value amount.

Okay, let’s look at some examples to drive these appraisal techniques home. In this case, we’ll say the appraisal is on a 10-year old 6-unit apartment complex, in good condition, consisting of 5,000 square feet, and includes garages, decks, and sprinkler system. Nearby vacant lots have recently sold for $120,000.

1. Cost Approach Assume the building can be built for $750,000 (including upgrades, decks, sprinklers, and garages). Deduct an amount for physical and functional depreciation, which we’ll say is $50,000. Then add site improvements (sidewalks, driveway, landscaping) which we’ll say is $30,000 and then the lot value of $120,000. The indicated market value using the cost approach is $850,000.
2. Comparable Sales Approach Assume that we located three comp sales in the area that supports a value range of $120 to $130 per square foot. We would multiply 5,000 by each to establish a ballpark range of $600,000 to $650,000 for the subject property. The sale price for each of our comps would then be adjusted up or down based on such things as sale and financing concessions, date of sale, location, floor plan, improvements and so on. We would then compare the comps, after adjustments, to our ballpark range and choose the most realistic. Let’s say $590,000 to $625,000.
3. Income Approach Assume that our three comparable rental properties sold at cap rates of 5.9%, 6.0%, and 6.1%. We would use 6.0% cap rate to estimate the value of our subject 6-unit apartment complex. Let’s say our NOI is $30,000, we then divide the NOI by the cap rate to arrive at a market (capitalized) value of $500,000.

As you can see, using the three appraisal approaches to estimate the market value of a property didn’t result in the same value. This is because you always work with imperfect data. In this case, after you arrive at market value using all three approaches, you must decide which approach best serves your real estate investing purposes.