I’m often surprised at the number of investors who do not know how to determine the value of real estate. As an investor, it is crucial that you are able to determine value for yourself and not leave it up to someone else.
The three primary yet different ways of determining value with real estate are the CMA, the Income Approach method and the Replacement Cost method.
The CMA method
The CMA (Comparable Market Analysis) method is based on what similar or comparable properties have sold for in the past, typically within the last three months.
The CMA is the most common valuation method for residential single-family homes. However, it’s typically the least favourable valuation method for investment real estate.
The Income Approach
The Income Approach method of valuation puts a value on the income generated from the property. This is the valuation method investors use most when evaluating an income property.
Finally, the Replacement Cost method of valuation is simply what it would cost to buy the land today and build a new building with the same square footage with similar features.
Let’s use an example to illustrate the differences between the valuation methods and assume for a moment that we are talking about a three-bedroom home with a two-bedroom basement suite.
The main level of the home is 1,000 sq ft and so is the basement for a total of 2,000 (finished) sq ft. The home is occupied by the seller and the seller collects $1,000 per month from the suite and the tenant pays for their portion of utilities in addition to their rent.
The seller is asking $400,000 since a Realtor told the seller that the CMA (Comparable Market Analysis) showed that similar properties in this neighbourhood have recently sold in this price range. This is the CMA value which is again what the market is currently willing to pay.
We can determine what the income is worth from an Income Approach method of valuation. Since the seller occupies the main house and we know the market rents in the area, we can quickly estimate that the home would rent for $1,500 month plus utilities.
Including the suite income of $1,000 we would have a total of $2,500 in total gross income. We then deduct all of the expenses, not including financing.
Let’s assume that we have calculated the property taxes, insurance, vacancies, advertising, management, repairs and maintenance and a monthly miscellaneous allowance totalling $900 in monthly expenses. That leaves $1,600 ($2,500 – $900) remaining each month which is the amount left over to pay a mortgage.
By running a simple mortgage calculation based on $1,600 per month for a mortgage payment using a 25-year amortization and a 4% interest rate, the amount of mortgage that a $1,600 payment can support is $304,000. Adding a 20% down payment of $76,000 on to the mortgage amount would give a maximum Income Value of $380,000. ($304,000 + $76,000).
To learn Hecht’s winning replacement cost method, download a copy of our February issue.