Valuation Of Income Properties

The basis for establishing the value of a residential home is the selling price of an equivalent property

. This basis however is not as effective in the case of rental properties. Imagine if you are looking at a 24-unit building. Chances are there is no record of a similar property sold in the recent past.

It's also not ideal to use replacement costs for income property appraisal. It will work only if there is a recent sale of a land recorded in a properly zoned area. This form of appraisal however will be a good indicator of whether to buy or build.

The Cap Rate Valuation Approach

Income properties are bought for the income. Income, then, is what is used to determine value. The expected return on investment over a period of time in a specific location is the capitalization rate, or the "cap rate" in that area. This is what you use to accurately appraise an income property. See the following example for a clearer picture.

Compute the gross annual income of the property. Compute also the total expenses for the year and subtract, not including loan payments. For example, if a building's gross income is $82,000 per year, and the expenses $30,000, you have a net (before debt-service) of $52,000. Then divide this figure with the capitalization rate.

Suppose the acceptable cap rate in the area is .10, for example (ask a real estate agent), meaning investors expect a return of 10% on the value of the property. What you do then is divide your $52,000 net income with .10 which would give a market value of $520,000 for your property. Let as assume that the accepted cap rate used by property investors in the area is .08. Your property then will be valued at $650,000.

Easy Real Estate Valuation?

Dividing the net income before debt service with the "cap rate": that is a straightforward process. However, the tough part is getting accurate income figures. For example, were all the operating expenses deducted? Did he and exaggerate the income? What if he stopped repairs for a year and projected a gross rental income? That would have resulted to the income being overstated by $15,000. The building would be worth $187,000 less (.08 cap rate) than your appraisal shows.

Experienced investors do not include incidental income from vending and laundry machines and other sources. If incidental income accounts for $6,000, that would result to an overvaluation of $75,000 based on the .08 cap rate. A more favorable process would be to exclude incidental incomes from the gross, and to include the replacement costs of the machines (should be less than $75,000) to get the appraised value.

The meaning of all this is to use a realistic valuation approach. There is no perfect appraisal method, and all are only as good as the figures you plug into them. If used wisely, though, appraisal by capitalization rates is one of the most accurate methods of real estate valuation.

by: Samuel Lasater

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