How Do Property Valuations Work for Real Estate Investors?
Whether you're an existing homeowner, a prospective homebuyer, or a seasoned real estate investor, understanding property valuation is important. Not only does home value provide insight into a home’s current value, but it also helps calculate property taxes and assess affordability of your next investment property.
Home values depend on a variety of factors such as location, square footage, and market conditions. There’s also more than one way to calculate property valuation. Keep reading to learn more about how property valuations work and how to use them to your advantage.
What is a property valuation?
A property valuation is a formal assessment determining how much a subject property is worth. This home value estimate is based on factors such as property size, floor plans, home renovations, property conditions, market conditions, age of the property, and location of the property. The property valuation is usually carried about by an appraiser who will provide a property valuation report.
Why does property valuation matter for real estate investing?
From a technical standpoint, property valuation refers to the assessment of future advantages derived from owning it. The benefits of owning real estate are normally realized over an extended period of time. Savvy investors won't invest in a property with a high current value in today's market, but a low value in the future. The idea is always for the subject property to grow in value.
As a result, evaluating a property's true worth requires not just an assessment of the property itself, but also of economic changes, social behavior, government regulations, and environmental conditions.
How are property valuations used?
Property values are important information for investors, lenders, prospective buyers, and local taxing authorities. Each entity uses home values for a specific purpose, whether it be to calculate ROI on investment or charge property tax to an owner. Property values are used by all of the following entities:
Mortgage lenders refer to a home value estimate as an appraised value. When a borrower applies for a mortgage loan, the lender calculates the borrower's loan-to-value ratio to determine how much they should lend the borrower. Generally, the loan-to-value ratio is up to 80% of the property’s appraised value.
Local and state governments
Local governments work with a property’s assessed value, which is used to calculate property taxes owed by property owners. Each state has its own property tax laws requiring homeowners to pay a percentage of their home's value in property tax.
Real estate agents
Agents and other real estate professionals use fair market value to determine the price at which a subject property could be sold in an open real estate market. Essentially, the fair market value represents a reasonable expectation of the buying or selling price based on the current market conditions.
Lastly, insurance companies use property values to determine customer payout when a claim is filed. Insurance companies work with two methods: actual cash value and replacement cost value. In either case, insurance companies need to know the home value.
7 factors that influence property valuations
As an investor, it’s important to know how property values are affected. Here are seven of the most common factors impacting home values:
1. Property size and floor plan
The square footage of a property and its overall floor plan influence home values. However, a bigger house doesn't necessarily guarantee a higher valuation. The number of bathrooms in relation to the number of bedrooms is particularly important. A four-bedroom, one-bathroom home may not be the best investment. Renters or buyers moving into a four-bedroom home either have a big family or multiple roommates. In either case, they’re going to need more than one bathroom in the house.
2. Home improvements
Adding a second bathroom or improving the kitchen can add to home value. However, these renovations tend to be expensive. According to a 2019 Cost vs. Value Report by Remodeling Magazine, adding a bathroom at a cost of $47,427 typically results in an increase in the resale value of less than $29,000. Investors should instead look for homes that either don’t require major home renovations or only require improvement projects with a high ROI.
3. Property conditions
Some renovations you can’t get away from and are necessary to keep your home in good condition. This is especially true if you’ve owned a home for some time. Failing to keep up with regular maintenance could negatively impact home value and reduce a home's desirability to new owners.
4. Property age
The older the property, the harder it is to stay on top of maintenance issues. As a result, new builds usually carry higher property values when compared to older ones. This is because a newer property implies lower maintenance costs and a longer period of time before significant investments are required.
5. Market conditions
It’s no secret that property values tend to increase in a seller's market. The rise in home prices is driven by an imbalance between supply and demand. In a seller’s market, there’s a limited amount of home inventory available and more buyers competing for them. As a result, home value increases across the board.
6. Property neighborhood
The neighborhood in which a property is located can significantly impact property values in a positive or negative way. Areas with a high number of vacancies, graffiti, and criminal activity, are less attractive to renters and buyers. On the other hand, property values generally tend to be higher in locations near schools, employment hubs, and lifestyle amenities such as shopping, dining, and recreation.
7. Location, location, location
Lastly, the location of a property plays a vital role in determining property value. Various locational factors such as property tax rates, rent control regulations, job market growth, and the susceptibility of the area to natural disasters impact property values.
How to estimate your property valuation
There are three main ways to evaluate a property’s value:
- Fair Market Value Approach: Real estate agents and appraisers use the fair market value to determine property value at any given time in the market. Often referred to as ‘comps’, this method involves comparing a property to similar nearby properties.
- Income Approach: The income approach is primarily used to value investment properties generating a steady rental income stream. Appraisers assess a property’s income potential by analyzing expense statements, rental rates, vacancy rates, market conditions, and other factors through the appraisal process. The projected income and cash flow are then used to determine the property's overall value.
- Cost Approach: The cost approach to property valuation is based on determining the value of a property by considering its replacement cost. This involves estimating the cost of replacing or reproducing the existing building on the current land plot. After calculating the replacement cost, depreciation is subtracted, and the value of the site is added to arrive at the property's overall value. This approach is normally used by insurance companies.
How to calculate property valuation
There are multiple ways investors calculate the estimated value of a property. However the three listed below are the most common:
The capitalization rate (cap rate) evaluates the relationship between the annual gross income of a rental property and its home value. The cap rate is calculated by dividing a property’s Net Operating Income (NOI) by its purchase price. For example, a property that brings in $40,000 a year and costs an investor $500,000 to purchase, has a cap rate of 8%. Investors typically look for a cap rate between 5% and 10%.
Try Azibo’s Cap Rate Calculator to understand whether a rental property may be a smart investment.
Return on Investment
Return on Investment (ROI) assesses the overall financial return on a rental property. Unlike the cap rate method, the ROI method accounts for financing costs needed to acquire the property, such as down payment amounts and interest rates. As a result, ROI varies from one investor to another.
ROI is calculated by dividing the annual return on the property by the total investment. For example, a property with an annual return of $15,000 ($40,000 NOI-$25,000 mortgage payment) and a total investment of $50,000 would have a 30% ROI. An ROI of 10% or above is considered healthy.
Try Azibo’s Return on Investment (ROI) Calculator to measure the profitability of your rental property.
Cash-on-cash return compares the cash flow generated by a property to the amount of cash invested. This method differs slightly from ROI because it focuses on the return for a specific period of time (usually a year), rather than the entire investment. You can calculate cash-on-cash return by dividing annual cash flow by the total cash invested.
For example, if an investor purchases a house for $500,000, makes a 15% down payment of $75,000, and spends an additional $25,000 on necessary upgrades, their total cash invested would be $100,000 in that first year.
Let’s assume the property is rented 12 months out of the year and brings in an annual NOI of $40,000, with an annual cash flow of $18,000 after deducting mortgage expenses. In this case, the investor's cash-on-cash return for the year would be:
$18,000 annual cash flow ($40,000 NOI - $22,000 mortgage expense / $100,000 cash invested ($75,000 down payment + $5,000 upgrading costs) = 0.18 or 18%. A good cash-on-cash return is between 8% and 12%.
The next year, the cash-on-cash return would be different because the down payment would be taken out of the equation. Vacancies can also fluctuate, which would reduce annual cash flow. Additionally, the property may need more repairs which would affect the cash invested.
Try Azibo’s Cash on Cash Return Calculator to evaluate your rental property.
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If you're wondering how well your current investment property is performing financially, or if you're looking to buy a new rental property, use Azibo’s calculators as tools to help inform your decision.