Property Valuation Tips: Real Estate Investing
Editor's Note: This post was originally published in March 2019 and has been completely revamped and updated for accuracy and comprehensiveness.
As a fix-and-flip real estate investor, accurately valuing properties is crucial to making profitable offers and predicting your potential profits. However, property valuation is often a complex process that involves considering multiple factors. Understanding the various real estate valuation methods used by appraisers can help you assess properties more accurately and predict your profits for any deal.
By knowing how much a property is currently worth, how much it will cost to renovate, and how much it's likely to be worth after the repairs, you can make more informed investment decisions. In this blog, we've covered the three most common real estate valuation methods used in house appraisals, giving you the tools you need to succeed as a fix-and-flip investor.
Property valuation overview
Buying real estate is unlike buying groceries, electronics, or other goods and services. Properties don’t have a fixed price tag, so they don’t have a fixed value. Like stocks, their values constantly shift based on what buyers are willing to pay for them. Yet value and price are not always the same thing in real estate.
Value vs. price vs. cost
When property owners plan to sell, they list the property for sale for an asking price. But buyers can and do make lower offers at a different price points.
Ultimately, the price that a property sells for may or may not accurately reflect its value. Imagine two identical homes right next to each other. One sells for $200,000, similar to other neighborhood homes. The other sells for $100,000, from a father to his daughter–a price that has nothing to do with fair market value.
Likewise, value and price often differ from a property’s replacement cost. A beautiful 200-year-old home may have a $500,000 market value based on what current buyers are willing to pay, but if it burned down, it might cost $600,000 to build an identical replacement based on today’s material and labor costs. In short:
- Price is what a buyer actually pays
- Cost is what it would cost to build a replacement home today
- Fair market value is what a stranger would theoretically be willing to pay for a home based on today’s demand for similar housing
Different types of value
Not all real estate valuation is created equal. Most commonly, value refers to "fair market value" outlined above. However, different types of buyers and sales methods can produce other types of values:
- Liquidation value aims to estimate a property's price at auction if forcibly sold (e.g., through foreclosure or bankruptcy). Liquidation value is nearly always lower than fair market value.
- Value-in-use is the value of a specific use of a property to a specific owner. For example, if a property is currently used as short-term vacation rental property by a small business, its value-in-use is based on its revenue and may be different from the fair market value that a homebuyer would be willing to pay.
Who evaluates properties, and how much do valuations cost?
In addition to the transacting parties, several industry professionals conduct inspections and offer input to the seller, buyer, and lender.
When a seller is looking to sell their property, they often seek a realtor's opinion on the value and listing price of the property. This opinion is usually provided in one of two ways: verbally and informally through a Comparative Market Analysis (CMA), or in an official report known as a Broker Price Opinion (BPO).
In a CMA, the realtor compares the value of the property to other similar properties in the local market, taking into account factors such as location, size, condition, and amenities. Using this information, the realtor provides an estimated value of the property and recommends a listing price.
On the other hand, a BPO is a more formal report that provides an estimated value of the property based on an extensive analysis of comparable properties in the market. It includes more detailed information, such as photos of comparable properties, market trends, and an analysis of the property's strengths and weaknesses.
Seeking a realtor's opinion on the value and listing price of the property is essential when selling a property, regardless of the method used. It allows the seller to make an informed decision and set a realistic price that attracts potential buyers while ensuring a fair return on investment.
While a BPO may not be as thorough as an appraisal, it can be completed faster and at a lower cost, typically between $125 and $225, when ordered separately. A qualified person, such as a real estate agent, real estate broker, or appraiser, can complete a BPO.
Broker price opinions are most commonly ordered by lenders who need a quick estimate of a property's value, especially when headed for foreclosure or loan modification. It's important to note that realtors typically don't charge property owners for a CMA or BPO if it's completed as part of a listing agreement.
Upon signing a contract with a seller, the buyer typically orders a home inspection and an appraisal. Home inspections are extremely thorough and often take several hours to complete. The home inspector evaluates the building’s structure, foundation, roof, mechanical systems, wiring, and functional age.
Home inspections range in cost from $300-450, depending on the size of the home. Buyers use this information to confirm that the property is in the condition they expected when they made their offer. Obviously, a home’s condition affects its value, and if the home inspection reveals a major structural problem in the foundation, then the property’s value will reflect the needed repairs. Read up on additional ways to make the most of a home inspection here.
Ideally, the home inspection should be performed before the house appraisal, so the appraiser can review the home inspection report and take it into account when forming the property valuation. The typical cost for a house appraisal ranges between $300-400. While the home inspector’s job is to assess the condition of the property and any needed repairs, the appraiser’s job is to estimate its value using one of the three valuation methods below.
3 Real estate valuation methods
Appraisers use three real estate valuation methods when determining a home’s value: the sales comparison approach, cost approach, and income capitalization approach.
Real estate appraisal method 1: The sales comparison approach
The most common way appraisers estimate a property valuation is by analyzing nearby comparable properties ("comps").
It makes intuitive sense: if you want to how much one property is worth, and an identical property just sold next door, that’s a pretty clear indication of value as long as it was an "arms-length transaction"—unlike the father-daughter example above.
Of course, rarely do you have identical properties selling just next door within the last few months. More often, appraisers must simply find the most similar properties they can, as near as possible, and sell as recently as possible.
Here are a few factors that appraisers must account for when reviewing comps:
- Home size
- Lot size
- Home age and condition
- Home amenities
- Location desirability
- Proximity to home in question (the closer, the better)
- Date of sale (the more recent, the more accurate)
Due to these variations in comps, property valuation is not an exact science. For example, what’s a more accurate comp: a property across the street with more bedrooms sold nine months ago or a property with a similar layout ten streets away that sold last week?
This is why three different appraisers would come up with three different values for the same property if hired to do so. House appraisals only estimate value, not guarantee a specific price. Learn all you can about how to use comps to determine home values so that you can analyze property values without having to ask realtors or appraisers for help constantly.
Andy Appraiser wants to estimate a home’s current value. The home in question has three bedrooms, two full bathrooms, and 1,500 square feet.
He looks at nearby homes that have sold recently and find three similar comps that sold within the last four months:
- Comp 1: 3 bedrooms, two bathrooms, 1,350 square feet. Sales Price: $195,000.
- Comp 2: 4 bedrooms, two bathrooms, 1,650 square feet. Sales Price: $235,000.
- Comp 3: 3 bedrooms, two bathrooms, 1,450 square feet. Sales Price: $205,000.
Andy estimates the property value at roughly $205,000-$210,000, having verified that the condition of all three homes was similar to his property in question.
Real estate appraisal method 2: The cost approach
When compiling a house appraisal, the appraiser can’t always find similar comps. For example, a rural house with no nearby homes can be difficult to value through the sales comparison approach. Unique properties, such as castles or converted churches, are also difficult for property valuation by comps since they’re unique.
An alternative real estate appraisal method is the cost approach. How much would it cost to buy the land and build the home?
Of course, the appraiser must take into account the property’s current condition. Building a new home from scratch would result in a perfect new house, and the existing house is likely not in perfect, new condition. So, appraisers use a technique called depreciation to estimate how much less the current home is worth compared to an identical brand-new house.
Some of the factors appraisers consider for depreciation include:
- The home’s physical deterioration: examples include old mechanical systems, old appliances and fixtures, and the condition of the roof, foundation, and other structural components.
- Functional obsolescence: an outdated way of building or structuring homes. For example, an upstairs layout where the only way to reach one bedroom is to walk through another.
- Economic obsolescence: neighborhood or other location-based factors that leave the property less valuable. An example is if a six-lane freeway was recently built right next to the property.
So, the appraiser uses comparable sales to estimate the value of the land itself, then estimates the cost of construction to replace the building. Finally, they estimate the amount of depreciation and subtract that from the value to reach a property valuation by the cost method.
Andy Appraiser has been hired to draft a house appraisal on a castle sitting on 100 acres. After reviewing sales of nearby undeveloped land, he estimates the value of local land at $5,000 an acre, which puts the land’s value at $500,000.
Andy then estimates that it would cost $200 per square foot to build a new castle using the same materials. The castle has 10,000 square feet, putting the replacement cost at $2,000,000.
But the castle needs significant renovations to be returned to like-new condition. Andy estimates renovation costs at $300,000, based in part on the home inspection report he received.
Thus, Andy calculates the castle’s value like this:
Gross annual income: $48,000 ($4,000/month) –
Annual expenses: $20,000 =
Local cap rate: 8%
Estimated value: $28,000 x (100/cap rate) = $350,000
Then he uses the gross income multiplier method. He finds that local rental properties are selling for around 85 times the rent. So, this calculation goes as follows:
$4,000 monthly rent x 85 = $340,000
Similar, but not exactly the same, as the direct capitalization approach. It’s up to Andy’s best judgment which is the more appropriate and accurate calculation in this case.
What fix and flip investors need to know about property valuation
One of the first lessons for flippers learning how to invest in real estate is to invest based on hard numbers, not emotions. Specifically, they need an accurate estimate of their costs and an accurate estimate of the after-repair value (ARV).
Costs include the acquisition costs (purchase price, closing costs), the cost to renovate the house (materials, labor, and other scope of work costs), and soft costs (such as carrying costs and other non-renovation costs).
But most relevantly here, flippers need to be able to estimate the ARV accurately.
For single-family homes to be flipped to homebuyers, investors can nearly always use the comparable sales approach as their real estate valuation method, both for the current value and the ARV. The appraiser will also follow this approach when the flipper or lender orders the house appraisal first to buy the property.
For properties intended to be flipped to buy-and-hold income, investors and appraisers sometimes use the income approach since the property’s use will be generating income. It’s uncommon for flipped properties to require a cost method appraisal.
As a crude shorthand, flippers can use the 70% rule to determine how much they should offer on a property based on their costs and the ARV.
As a real estate investor, accurately estimating the current and after-repair values of your fix and flip properties is crucial for various reasons. Firstly, it helps you determine the potential profit margin of the investment. In case the repair costs and other expenses are too high, the profit margin may be too low, making the investment less worthwhile.
Accurate estimates of property values also enable you to make informed decisions about whether to purchase a property, how much to pay for it, and how much to invest in repairs and renovations. Moreover, it helps you set the right price for the property and attract potential buyers. Overpricing the property could mean that it sits on the market for an extended period, reducing your potential profit.
Finally, when applying for financing, lenders often require accurate estimates of property values. Without accurate estimates, you may not secure the necessary funds to purchase and renovate the property.
When using banks or other hard money lenders to finance your fix & flips, waiting on appraisals is often a hurdle. Kiavi instead uses an internal valuations team that speeds up the process, getting you to the closing table quicker!
About the author: G. Brian Davis is a real estate investor who has owned dozens of investment properties over the last 15 years. He’s also the co-founder of SparkRental.com, an online resource which provides free landlord education and video series for anyone looking to build passive income from rentals.