You've located the property that you are potentially interested in purchasing, have looked at it, and determined that it meets your basic investing goals. Before you pat yourself on the back for a job well done, you need to establish its value to avoid potential financial disaster. If you take the word of the seller or the county tax rolls to establish its value, you could lose your shirt, especially in a real estate market that has seen values drop by tens of thousands of dollars within a matter of months.
Depending upon the kind of investor you are you'll utilize one of the three methods of establishing the value of a property. They are:
Comparable Sales – If you're investing in primarily single-family or multifamily properties with fewer than five units, by far the most popular method of establishing value is the comparable sales method. This method consists of locating recently sold properties that are substantially similar to the one you are considering purchasing and are located in the same general vicinity. A skilled appraiser typically has many years of experience in determining value, but you can do the same thing either by going to your county courthouse and compiling the information yourself or by working with a realtor who might be willing to provide these figures to you. You can also get a rough estimate of values in many areas by utilizing an on-line resource such as Zillow.com. Once you have your comparable sales figures you'll need to compensate for any differences, such as the lack of a garage, fireplace, or even a swimming pool. In order to compensate for the differences in square footage of your subject properties, you can divide the sales prices by the square footage of living space to come up with a cost per square foot.
Replacement Cost – While not nearly as popular as the Comparable Sales method, another way of determining the value of a property is by estimating what it would cost to re-create the same property in the same area. You would need to determine building costs, the cost of materials, and also make allowances for depreciation of the property so that it is substantially similar to the property you are considering purchasing. If you're experienced at estimating building costs accurately and are aware of the current cost of building materials and supplies, the replacement cost method may be one which you will want to utilize. However, it isn't utilized very frequently. If the Replacement Cost method is one that you'd like to use to determine value, you could very quickly arrive at a figure by contacting a local contractor and asking them how much they would charge you by the square foot to build a home in the area of your subject property. Don't forget to factor in depreciation to match the condition of your subject property.
Income Valuation Method – The third method of determining the value of a property is to use the Income Valuation Method, sometimes referred to as the Net Income Approach. This method is used to determine the market value of a commercial property or a residential property with more than five units. It's a relatively simple process. First, determine what the gross income is for the property and then subtract all expenses, including debt service on an annualized basis. Multiply that figure by a factor of ten. The resulting number is about what your property is worth. What's nice about this sort of property is you can increase its value simply by increasing its net income, reducing operating expenses, or both.
Once you're able to determine the value of a property you can write an intelligent offer that doesn't cause you to run the risk of overpaying for a property. Remember, though, that real estate prices are extremely volatile right now, so make sure any properties you use for comparative purposes are recent sales figures. If you have accurate numbers, you can write impactful, precise bids that stand a greater chance of being accepted and allowing you to turn average returns into explosive profits.