Learn to Value the Real Estate Investment Property
The real estate investment is just like a stock investment if you see it’s quantitative perspective. To identify the profit, as an investor you should evaluate the property’s value. By giving value to the property you buy, you will be able to guess the profit margin you will generate by the transaction.
Equity Valuation
Equity valuation method is used to evaluate the value of the property by the 2 basic methods.
- Absolute Value
- Relative Value
The absolute value is discounting the future net operating income (NOI) by the adequate discount rate for the real estate property which is similar to discounted cash flow (DCF) valuations for a stock.
The relative value is integrating the gross income multiplier model in the real estate property which is comparable to relative value valuations with stocks.
The Capitalization Rate
Choosing an appropriate capitalization rate is first and foremost assumption requires in valuing the property. It is the demanded rate of return in the real estate property. Net value of appreciation and depreciation. The capitalization rate is the rate which is directly applied to NOI to describe the present value of the property.
For example, if a home is expected to generate Net Operating Income of $1 million over the next 10 years and it is discounted at a capitalization rate of 14%. And the market value of the property is determined as $1,000,000 / .14 = $7,142,857, the net operating income is divided by the overall capitalization rate which is equal to the market value.
The $7,142,857 market value exhibits a subtle deal. But only if the property is selling at $6.5 million. If it is selling at $8 million then it would be worst deal.
The Build-Up Method
The one method to identify the property value is the build-up method. It includes the interest rate, liquidity premium, recapture premium, and risk premium.
If the interest rate is 4%, a non-liquidity rate is 1.5%, a recapture premium rate is 1.5% and the risk premium rate is 2.5%. Then the capitalization rate of an equity property would be calculated as 6+1.5+1.5+2.5 = 11.5%. If the net operating income is $200,000.
Then the calculation shows the result: $200,000/.115 = $1,739,130. $1,739,130 that is the market value of the property.
The Market-Extraction Method
The assumption in this method is that there is a current and ready Net Operating Income and Sale Price is available. The core benefit of the market-extraction method is that the capitalization rate can make the Direct Income Capitalization more powerful and meaningful.
Valuation of the capitalization rate is simple here. Assume an investor is pondering to buy a parking lot which is expected to generate $500,000 in Net Operating Income. Here, there will be 3 existing comparable income generate of the parking lots.
If the parking Lot 1 has a Net Operating Income of $250,000 and the Sale Price is $3 million. Then according to the calculation, the capitalization rate is: $250,000/$3,000,000 = 8.33%.
If the parking Lot 2 has a Net Operating Income of $400,000 and the sale price is $3.95 million. Then by the calculation the capitalization rate is: $400,000/$3,950,000 = 10.13%.
If the parking Lot 3 has a Net Operating Income of $185,000 and the sale price is $2 million. Then the capitalization rate is: $185,000/$2,000,000 = 9.25%.
By all the calculations and comparing all these 3 parking lots it is determined that investment value would be $500,000/.094 = $5,319,149. And the overall capitalization rate is used is 9.4% which gives a reasonable presentation.
The Band-of-Investment Method
The capitalization rate is computed as
Interest rate / 12 months
{[1 + (interest rate / 12 months)]# of years x 12 months}-1
By adding the values:
.07/12
{[1 + (.07/12)]15x12} – 1
= 0.003154
Multiply this value with 12 for annual valuation.