No one wants to pay too much for something, especially an investor seeking solid returns on his or her money. So, if you're looking for good investment real estate, how can you determine what a prospective property is worth? Some say that value is determined by the deal. But how can you make a truly good deal without first having some idea of the property's value? Inexperienced investors often tend to confuse the concepts of "fair market value" and "market price." Your objective as a savvy investor should be to estimate a property's fair market value as accurately as possible, and then negotiate a deal at a market price below that estimate. First, however, you must be familiar with what each of those two terms actually means.
The term fair market value is essentially defined as the highest price that a ready, willing, and able buyer is likely to pay and the lowest price that a ready, willing, and able seller is likely to accept for a subject property. It's the probable price based upon the assumption that both the buyer and seller have sufficient information and that the property has been on the market for a reasonable period of time. FMV, as it's also commonly known, is always an estimate. Market price, on the other hand, is the actual amount that a property sells for in a given market. This price may actually be higher, lower or equal to the fair market value estimate.
In order to estimate market value, it's possible for you to use the same tools and methods that professional appraisers employ. The three most commonly used appraisal techniques are market data, replacement cost, and income analysis. For some properties, you may find yourself using all three of these evaluation methods, while other cases will only need one or two. Let's look now at a simplified explanation of each of them.
The market-data method of valuation (also known as the sales-comparison method) is the technique most widely used for estimating the market value of single-family- and two- to four-unit multifamily properties. It's essentially the same procedure used by real estate agents to help home sellers set their asking- and probable selling prices. Among listing agents, it's commonly called a comparative market analysis (CMA).
The market-data estimate of fair market value is obtained by comparing the subject property with "comparable" properties that have recently been sold. Comparables are properties sold within the previous twelve months that are similar to the subject property in size, style, age and condition. Location is also an important factor in the reliability of a given comparable property as a market value estimator. The closer and more similar the comparable's location is to that of the subject property, the more likely it is that fair market value will be similar. As each comparable is compared to the subject property, adjustments are made for differences in location, physical features and amenities, time on the market, and any changes in local economic conditions.
In today's modernized and technology-driven marketplace, the market information necessary to do a CMA is readily available by computer using data stored in Realtors' files. If you're working with a Realtor, whether your own buyer's agent or the seller's, be sure to ask to use this method to estimate the fair market value of the subject property before making your first offer. If you don't have a Realtor's help you'll likely find it somewhat more difficult to do a market-data valuation, but it certainly won't be impossible. You'll need to spend some time at the local county government building. The tax assessor's office keeps files on every property (including the selling price) in its jurisdiction as part of the public record. Once you've collected the selling prices and other pertinent information of several properties that are similar to the one you're considering, you'll be able to compare physical features and amenities and make your evaluation accordingly. What you won't be able to glean from the tax records, however, is time-on-the-market data, which could possibly have made a significant difference in the prices that the owners were willing to accept for their properties (the longer the time on the market, the more willing the owners might have been to reduce their selling price).
To use by the replacement-cost method of valuation, you must first fundamentally presume that the property can be reproduced or replaced, so you estimate that cost. Except in those cases where preservation for historic purposes has a bearing, most investors typically calculate replacement cost estimates under the assumption that current materials, tools, and technology will be used to build the replacement property.
The replacement-cost technique is usually employed when there are few similar properties in the area, thus making a market-data analysis difficult. It's also typically used when there will be no income from the property. For example, a fixer-upper property located on a country road and bought for the purpose of flipping it (reselling it quickly) would not be appropriate for either a market-data- or income-analysis evaluation. Keeping things simple, there are five basic steps to appraising such a property's value using the replacement-cost method:
- First, estimate the value of the land.
- Next, estimate the current cost of replacing the structure with a similar one.
- Estimate the amount of accrued depreciation.
- Deduct the estimated accrued depreciation amount (Step 3) from the estimated replacement cost (Step 2).
- Finally, add the estimated land value (Step 1) to the value calculated in Step 4.
The income-analysis method of appraisal ties the value of an investment property to the income that it's likely to produce. Again, for simplicity's sake, there are two basic techniques that can be applied to accomplish this: the gross rent multiplier and the capitalization rate. Both depend upon gathering data from similar properties in the area.
The gross rent multiplier (GRM) is most often used for appraising single-family investment homes or two- to four-unit multifamily structures. An appropriate sales price is calculated for the property by using its probable monthly rental income as a comparison factor against the monthly rental income and actual sales prices of comparable properties that were recently sold in the area.
Capitalization rate is typically used for larger investments, such as apartment complexes, office buildings and shopping centers. It can, however, be applied to mixed-use buildings and multi-family homes. With this method, the estimated market value of the property is calculated from the expected return that's typically being generated by similar investment properties in the area.