Why Is the Appraised Value the Accurate Value of Real Estate?
You may have read my prior Accury articles on becoming a real estate appraiser or on how you need to have your property valued when you put it up for sale or you decide to purchase a property. If so, you probably know that a home sale requires a home appraisal.
Why the Appraised Value of a Property Describes Its Actual Value?
You can estimate a home’s value using various websites to look up the current value of a home, but determining the actual home value takes more than knowing the price for which it last sold. During the home sale process, this means a home appraisal to determine the home’s value.
The home appraisal comes before the home inspection. While they each have a different outcome, they make up part of the same process. The appraisal determines the actual current value of the home, so the seller asks for an appropriate price and the bank knows that it provides an appropriate amount for the mortgage loan.
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Importance of Real Estate Accurate Value in Home Buying
That explanation may sound overly simplified and it is. As we will learn in this article, real estate valuation is a complicated proposition. The appraised value and the accurate value describe the same thing. They do not describe the value of the property as originally built or the value of the property when its current owner purchased it.
You might think that unfair, but it does provide an accurate value of each property. So, your home or commercial property really has three values. Here is the definition of each:
Original Value
The original value of the home or commercial business is the value as it was built. For example, a home built five years ago at a cost of $300,000 would have an original value of $300,000.
Last Purchase Value
The purchase value refers to the price the current owner paid for it. For example, the original owners sold the $300,000 home two years after building it, but only got $250,000 for it because the neighborhood had gone downhill and the other two homes that had sold had also brought lower values than at which they were initially built.
Appraised Value
The current valuation of the home itself as compared to other homes in the neighborhood that sold recently. For example, the buyer who paid $250,000 for the home, moved in and immediately helped begin a neighborhood watch program and a revitalization program. This raised property values in the entire neighborhood when it began cleaning it up. Once the unsavory elements were eradicated, property values soared. Three years passed and the homeowner decided to sell. The new appraisal valued the home at $325,000.
The appraised value is the accurate value of the real estate. The appraised value of $325,000 represents the actual value of the home. It describes the current state of the home and its surrounding neighborhood especially the homes that have sold in the past three months and their sales values.
Now, you can have an appraisal result in one of two types of value – appreciated value or depreciated value. You want the former. Trust me.
Appreciated Value
An appreciated value refers to a value that increased or experienced growth. Most properties increase in value over time or appreciate. Location most greatly influences appreciation.
Depreciated Value
A depreciated value refers to a value that decreased or experienced a loss. If a neighborhood declines while you own a property, your property values will decrease. The other item that can cause depreciated value is lack of home maintenance. If your home becomes dilapidated, it will reduce its value.
Real Estate: Accurate Value in Investing
You cannot discuss the accurate value of real estate without delving into the accurate value of the real estate in investing. This is where things get complicated. The old saying goes that a house is worth whatever someone will pay for it, but you need to make money on your investment. You cannot overpay for a home or investment property because that cuts into your profit. That means you need to learn to distinguish a good investment from the one you should pass on because it has too high a risk.
Most people do not invest in real estate so you probably do not see this part discussed in most introductory articles. The closest thing to investing in real estate most people come is purchasing a vacation home.
So, What Does Define a Real Estate Investment?
Well, actually, many things.
Typically, an individual purchases an investment property on their own. Larger properties, such as corporate office complexes, have a number of investors who pool their money. They purchase shares.
These are the typical types of individual investment properties:
1. Single-Family
A condo or house purchased to flip (quickly re-sell) or to lease/rent to an individual or tenant. These purchases typically include foreclosures or fixer-uppers purchased cheaply, then repaired to sell for a quick profit. These single-family properties require a smaller investment, but in times of economic hardship, you will find it tough to flip. As long as you have a rental vacancy, you will have zero returns, so finding and keeping a tenant becomes vastly important.
2. Second Home/Vacation Home
A secondary house purchased to rent or lease that the owner may use when not leasing it to another home. Earning a rental income qualifies it as an investment property. It provides a passive income, but your investment earns zero returns until there is a tenant.
3. Small Multifamily
A small multi-family structure consists of a two- to four-unit home or building that may be partially owner-occupied. It is the most common investment property type for first-time investors. This option results in stable returns since in any economy, people need housing and apartments provide a cheap option. Leases typically last one year sometimes resulting in a turnover. Multiple units mean you will earn income so long as at least one unit remains rented. Prolonged total vacancies will impact your return on investment.
4. Large Multifamily
A multi-family structure comprised of five or more rental units. This is also considered a small apartment complex. Occasionally, the owner occupies one of the units, but typically, all of the units get rented by tenants. While you typically earn a stable ROI and a vacancy will not negatively impact profit to the extent of smaller rental property types. You will have more significant operating and maintenance costs. These leases also typically last one year and can result in a turnover.
5. Mixed-Use Investment Property
A mixed-use property includes both residential units and commercial units. Frequently located in urban areas, this combination typically locates offices or commercial enterprises on the first floor with apartments above it. This provides two income streams and a steady ROI. These produce more risk for the financial lender since they typify a riskier investment. Mixed-use structures cost more to build, but produce consistent earnings.
6. Office Investment Property
An office property can consist of a single tenant or multiple tenants in offices. These require large investments and vacancies to produce a larger impact on ROI. The success of these buildings depends on the economy.
7. Retail
A retail building differs from an office building since only retail stores occupy it. It may consist of a single retail outlet or many retail stores in a single building, such as a shopping center or shopping mall. The ROI depends on the economy.
8. Industrial
A property typically housing one renter only typically falling into the categories of manufacturing, warehousing/storage, or a distribution center. These require a smaller investment, but the structures can end up being industry-specific which reduces the pool of potential renters.
9. Land
A land purchase takes one of four investment approaches - buy and hold, buy and flip, buy and rent or buy and build. Depending on the approach, you either earn a quick passive income or must go through the entitlement and zoning process before building. This provides the greatest risk both to the investor or to the financial lender since it involves land speculation.
Gasp. Yes. Real estate investing is that diverse and complex. As you might guess, the process of valuation of each type of property differs. If you recall the article on how to become a real estate appraiser, you know that you must obtain higher levels of education in order to appraise the more complex types of real estate.
That special training required is because each property type differs as do the items that provide its value. A piece of as yet undeveloped land would undergo a different appraisal than a single-family home, whether for a primary residence or an investment.
Accurate Value of Real Estate: Topics in Valuation
This may or may not be what you expected to read here, but it matters which methodology you use. Each of these factors in valuation affects the actual value which is the appraised value.
Capitalization Rate
The term capitalization rate refers to the rate applied to the net operating income of an existing property to determine the present value of the property. The capitalization rate describes the required return rate on real estate net value. You would use the following formula:
net operating income / overall capitalization rate = market value
The market value should exceed the asking price of the property to make a good investment.
How do you know what capitalization rate to use though? I mean, obviously, you cannot simply pull a random number out of thin air and have it work. The capitalization rate is not constant. You must determine the appropriate variable for each distinct situation.
If you have ever calculated the weighted average cost of capital (WACC) of a business in which you were considering investing, you have some experience in a similar calculation. The real estate calculation proves more complex though. The initial step is to determine the method you want to use to find the appropriate capitalization rate.
You might say, “Hey, Carlie, if the property already has a value, why can’t I just use that?”
Well, as much as you would like to have such a simple investing decision, it does not work that way. The current value of something does not equal the future value or the past value. Just as a neighborhood goes through changes, so does the property’s value. Similarly, you cannot expect to earn the same ROI as the last individual. If you are new to investing or real estate investing specifically, here is why. While with investing in stock, your ROI gets determined by the effort of the firm in which you invested, in real estate investing, it is all up to you.
You might advertise better than the last landlord or you might rent to family members only, ensuring you never have a vacancy and no one destroys the house or apartment building. You might make many decisions differently than the current owner or the one before that, so while the seller’s asking price and the current leasing status have some bearing, you also must determine the capitalization rate to determine the actual market value of the home or other structure.
There are a few methods of finding the right capitalization rate. Let’s plow through each, starting with the built-up method.
1. Built-up Method and the Accurate Value of Real Estate
Let me be straight with you. This method uses really easy math. The complicated part is accurately assessing the estimate of each factor needed to calculate the capitalization rate. It does try to create an accurate measure of both the individual items that go into a discount rate and the discount rate thereby. You need the four following items:
the interest rate,
the appropriate liquidity premium that accounts for real estate’s illiquidity,
the recapture rate for premium accounts for net land appreciation,
a risk premium rate that captures the real estate market’s overall risk exposure.
You probably won’t have to look hard for the interest rate. You can plug that sucker in easily. Your non-liquidity rate, recapture premium, and risk rate depend on your study of the economic situation of the moment. They are not constants. Finding the capitalization rate is as simple as summing the four variables. That is all. Easy, huh?
Let’s say your interest rate is 6.2 percent and your research determined you need a non-liquidity rate of 1.5 percent, a recapture premium of 1.5 percent, and a risk rate of 2.6 percent. You sum them.
6.2+1.5+1.5+2.6 = 11.8 percent
Here is where this probably will throw you off. Finding the capitalization rate is one thing, but you need to understand that your current pursuit is to determine the market value of the investment property which differs from the actual or appraised value. The latter is the asking price which is likely to be your purchase price, but the market value refers to how much it is worth to you to buy it, in essence. You want to earn more from the property as you rent it or flip it than you pay for it, so you ideally want to buy it for less than it is worth.
Let’s say the net operating income of the current owner is $300,000. You apply your capitalization rate by dividing the net operating income by the capitalization rate. So, the market value is:
$300,000/.118 = $2,542,372.88.
Now, you need the appraised value of the property which represents the actual value of the property. Ideally, your investment property you want to buy will cost – in asking price based upon the appraised value – less than the market value of the property. You want to know you will make money.
So, if the building’s appraised value/asking price costs more than the market value, it would make a poor investment. If it costs less than the appraised value/asking price though, it would make a good investment. You want the building to earn more in income each year than you pay in maintenance and mortgage. That provides your ROI.
What about other methods of calculation you ask? I am SO glad you asked! It turns out, I have an explanation for that in my back pocket, so to speak, thanks to a class or two with Dr. Dan Sutter when I was at the University of Oklahoma.
2. Market Extraction Method and the Accurate Value of Real Estate
Next, we will tackle the market-extraction method. Okay, this one figures you will walk into a great situation with immediate net operating income.
Did you just say “Huh?”
Immediate net operating income means that you would walk into a situation where the units were already rented. That means if you bought the building, you would also buy the existing leases and thereby make money immediately.
This method also uses the assumption of sale price information on comparable income-generating properties. In plain talk that means it estimates that you will pay the same as other buildings in the area that make about the same because they are about the same size with the same number of units and require about the same in rent.
This means that you will study the comparable properties in the area to determine how the one you want to buy compares with them. It uses simple math and no fancy economic terms, but it does give you a clearer picture of the property value as well as the more basic step in your competition analysis should you invest.
Let’s say you want to buy a parking lot with a current net operating income of $500,000. Find comparable income-generating properties in the same area. You obtain the net operating income of each and its last sale price which would be its last appraised value. You get to cut to the chase with the calculations this time.
You will divide the net operating income of each property by its sale price. With three other lots in the same area, you have three sets of figures to obtain from the city clerk and tax filings.
Parking Lot 1 sold for $4 million and produces a net operating income of $250,000.
$250,000/$4,000,000 = 6.25 percent capitalization rate
Parking Lot 2 sold for $2.95 million and produces a net operating income of $300,000.
$300,000/$2,950,000 = 10.16 percent capitalization rate
Parking Lot 3 sold for $2 million and produces a net operating income of $195,000.
$195,000/$2,000,000 = 9.75 percent capitalization rate
Basing your capitalization rate on the comparable properties results in an overall capitalization rate of 8.72 percent. To find the market value of your intended property purchase, you would divide your potential net operating income by the capitalization rate.
$500,000/.0872 = $5,733,944.95
Compare that market value with the appraised (actual) value of the property to decide whether it is a good investment for you.
3. Band-of-Investment Method and the Accurate Value of Real Estate
Your choice of the method used to arrive at the appropriate capitalization rate depends on many factors. You might use debt financing or equity financing. Using the band-of-investment method works best for financed real estate investments.
Time to learn some econ again:
You need to calculate your sinking fund factor. The sinking fund factor refers to the percentage you must set aside during some number of fiscal periods to save an arbitrary amount of funds by some future point in chronological time.
Let’s explain two parts of that explanation further. The some number of fiscal periods can refer to fiscal quarters or months. In the formula I provide you, you will use 12 months, so this is the amount you would put into savings each month.
The sinking fund factor would be calculated as:
\dfrac{\frac{Interest~Rate}{12~Months}}{{[1 + (Interest~Rate / 12~Months)]}^{(\#~of~Years * 12~Months)}-1} [1+(Interest Rate/12 Months)]
(# of Years∗12 Months)
−1
Do not freak out. That is really a lot easier to calculate than it looks like it is:
The property produces a net operating income of $950,000.
It is 50 percent financed.
You landed a 7 percent interest rate (good job) and the mortgage will be amortized for a period of 15 years.
You paid for the remainder with equity at a required rate of return of 10 percent.
Divide the interest rate by the months first…
.07/12
then do the nifty stuff in the brackets.
{[1 + (.07/12)]15x12} – 1
The one is a constant here. That .07 is your interest rate again. It is divided here by 12 months, too. The 15 refers to your amortization years and the 12 refers to the months in a year.
Once you have done that and have your nifty number, you subtract the 1.
Unless you have a scientific or engineering calculator handy, you will probably find doing this calculation easiest in Excel. It lets you easily create formulas to calculate everything at once, so you do not have to save portions to a calculator, then complete another portion.
You get .003154 per month which you need to transform to a per annum.
.003154 x 12 months = 0.0378.
So, you must pay the financial lender the sinking fund factor and the interest rate. You add the two numbers together.
.07 + .0378 = or .1078 (also known as 10.78 percent)
Now, you have to apply the weights, so you get the accurate weighted average rate which is also your overall capitalization rate.
*pant, pant* Come on. You can do it. We are almost finished with this one.
You use a 50 percent weight for debt and the same for equity because remember up there where you financed 50 percent of the purchase with equity? That is where the .5 in the following formula comes from, just so you know. You use the .1078 figure because that is what you calculated for the loan with your interest rate factored into the equation.
(.5 x .1078) + (.5 x .10) = 10.39 percent
Now, you get to apply the capitalization rate to the net operating cost. Are you SO excited?! You’ve come a long way, baby, as the old cigarette ads said.
$950,000/.1039 = $9,143,407
Oh, look. You have a market value of $9,143,407. You can compare that to the appraised (actual) property value to determine if the property purchase would make a good investment.
This gives you the most accurate valuation, but it takes awhile. Yeah.
I won’t be cruel. I will save the topic of comparable equity valuations and the accurate value of real estate for another article. Sure, it is related to what we are talking about, but your brain is probably ready to burst and I have steak and potatoes waiting on me.
Finally,
Now, you know why the appraised value of a property describes its actual value, but other valuations also exist. Typically, real estate appraisals and valuations for investment properties cover the investment potential of the property and you do not want to confuse the two. You need for your market value to be the larger of the two, so you get the best deal. When your market value outweighs your appraised value, the forecast for your investment is sunny and bright.