Real estate valuation is based upon the principals of economics. Whether its residential or commercial real estate, an office building or apartment building, the value of real estate involves the forces of supply and demand in the marketplace.

Sound investment analysis requires the application of these economic principals to correctly determine real estate value, and real estate investors would be wise to understand them. So let’s take a look.

Anticipation is the expectation of future benefits. Value is a function of the anticipated future income stream from a present value standpoint. Investment value is estimated from the future annual cash flows plus the reversion (sale).

Conformity is defined as the need for reasonable similarity and compatibility in a given location. Compatible land uses may generate higher values. It is, however, possible to over-improve a site and not actually recover the cost it took to build because of limitations imposed upon the property due to location.

Change is important as it may establish trends that will be useful in forecasting future change, and the impact these changes may have on value and the feasibility of the real estate investment opportunity.

Supply and Demand forces operate to establish price. Investment properties with similar physical and economic characteristics will sell for similar prices, but many underlying factors may impact transaction price, including the terms and conditions unique to the individual investment and investor. Supply and demand must also be placed in the context of shortrun and long-run considerations. In the short run any given type of investment property is fixed in supply. In the long run, which is defined by all costs being allowed to vary, the supply can change as appropriate to meet the demand.
Highest and Best Use is a concept that encompasses the highest use and the best use of the property. This concept identifies that use that will exploit the land to its greatest advantage. Highest and best use is usually identified through its legally possible, appropriately compatible, physically possible, and economically and financially feasible characteristics.

Increasing and Decreasing Returns apply to value, as the law of diminishing returns in economic theory suggests that as more variable factors are added to fixed factors, the benefits will first increase at an increasing rate, then increase at a decreasing rate, and finally decline.

Contribution is defined as the change in the total amount of product as the result of adding additional units of input. In this case, of course, the cost of adding units must be equal to or less than marginal revenue to be economically advantageous.

Substitution is an opportunity cost concept. Given alternatives, with similar levels of risk, the investor should pick the least costly alternative to provide any given level or rate of return. Alternatively, a rational real estate investor will not pay more for an investment property than what the next best substitute will yield in benefits.

There are different ways investments in real estate can be approached.

The “how-to” approaches to investment are those popular nontraditional approaches taught by gurus who emphasize a slightly different aspect on the way to riches in real estate investment.

The “how-to” or nontraditional approaches to real estate investment typically involve a basic theme: exploiting weaknesses in the real estate investment market.

For example, these approaches rely upon finding investment property that can be upgraded and a profit made from exploiting that potential. The idea is to find rental properties that can then be renovated and marketed at a higher value.

Similarly, when properties are under rented, the approach calls for renegotiating leases at prevailing market rates to enhance cash flows and ultimately, market values.

Finally, some nontraditional approaches involve specialized techniques for financing or marketing the property to maximize its value and hence, profit the entrepreneur-investor.

Gurus, of course, have their own “how-to” real estate investment strategy, but each includes a real estate investing flaw–most approaches do not balance the favorable aspects of investing with the obvious risks involved. Little is said, for example, of the dangers of negative financial leverage–borrowing funds at a cost higher than their return or business risk.

Moreover, the time value of money is ignored, and because the analysis is usually based on one year of cash flows, no change in income streams over the holding period is commonly taken into consideration.

In other words, one of the most important points about real estate investment is what most “how-to” proponents neglect to teach.

Real estate investing requires attention to both favorable and unfavorable aspects of any given investment opportunity. Risks must be balanced with rates of return. This involves looking at quantity, quality, timing, and durability of the cash flows over the anticipated holding period.

Simply put, real estate investing involves more than buying “handyman” specials or finding older owners who might finance the sale of their property, though they should be considered if one is lucky enough to stumble across one.

No, real estate investment requires more than market exploitation to be consistently successful–it takes a specialized knowledge of investment analysis for a unique investor who is in a unique investment situation.

When rental property is being valued, any number of values can be arrived at depending upon the definition of the value being sought–a real estate investor buys rental property based on the specific value that is important to the investor.

The investment value to an investor is the present worth of future, benefits that will provide a specified target rate of return at the level of risk that is acceptable to that investor. This value implicitly involves the investor’s unique tax shelter requirements, availability of equity, capacity to borrow, management strategies, required rate of return, etc.

For example, suppose the investor requires a return of 6.0% on the capital that must be invested to purchase a series of future cash flows a rental property is expected to generate over time. In this case, both internal rate of return (IRR) and net present value (NPV) might be used to determine whether investment objectives will be met.

The market value estimate, using the income approach to value made by an appraiser involves a market orientation in which the market is researched to provide typical or average values. An appraiser may use a capitalization process that converts an income stream into some present value using market-derived data.

For example, suppose an apartment complex has a verified net operating income NOI) of $150,000 and a market-derived cap rate (C.R.) of 10.0% was determined. In this case, a market value of $1,500,000 for the apartment complex would be determined: NOI / C.R. = Value

The bottom line for real estate investors is to define which type of property valuation is important and apply that value to any rental property being sought.