Property Valuation Methods You Should Know
Reviewed by Gordon Scott
Fact checked by Suzanne Kvilhaug
When investing in real estate, knowing how to value property well in an often-shifting marketplace often means the difference between a profitable venture and a costly lesson. Better approaches to real estate valuation are systematic in how they assess income potential, market conditions, and comparative properties.
“With direct property purchases, you need local knowledge about the market, culture, tax system, and much more,” said Harm Meijer, author of “Real Estate Rules: The Investor’s Guide to Picking Winners and Avoiding Losers in Listed Property.”
While stocks can be valued using readily available market data and standard metrics (earnings per share, dividend ratios over time, etc.), real estate doesn’t always have that. Thus, valuing properties might take more effort. However, the reward might be finding deals others often aren’t willing to work for, Meijer said.
Key Takeaways
- Real estate valuation uses absolute (like discounted net operating income, or NOI) and relative methods (like gross income multipliers) to determine a property’s worth.
- The capitalization rate is a crucial metric used to estimate a property’s value based on its NOI and market conditions.
- When determining the value of a property, you’ll need to account for vacancy rates, operating expenses, and changes expected to affect future income.
- Real estate markets are generally less transparent than stock markets, making it more challenging to get solid comparative data.
- For this reason, good property valuation requires careful research analyzing characteristics and metrics related to the property itself and broader market conditions.
Property investors need to compare different valuation approaches, including calculating capitalization rates and NOI. For a well-rounded valuation, Meijer recommends combining both absolute valuation methods—which look at a property’s intrinsic value based on its income potential—and relative valuation methods, which compares a property to similar assets in the market. But he and other experts wouldn’t have you stop there. We cover why that’s the case and more below.
Capitalization Rate: Key to Property Values
One of the most important tools for valuing income-producing properties is the capitalization rate, or “cap rate.” This measures a property’s value based on potential income, similar to how bonds can be assessed based on their expected yield, not merely on how much you can sell them for.
The cap rate is used to convert a property’s annual NOI into an estimate of its value. For example, suppose an apartment building generates $1 million in NOI each year. If you determine the right cap rate is 14%, the property’s estimated market value would be as follows:
$7.14 million = $1 million ÷ 0.14
As such, if the property is listed for $6.5 million, it might be worth the asking price. However, if it’s selling for $8 million, it could be a bad deal.
While understanding a property’s capitalization rate is essential, Meijer emphasized that it’s only one piece of the valuation puzzle. “Many investors fixate on property yields without considering what drives long-term returns,” he said. “What really matters is a property’s ability to generate consistent rental growth while keeping capital expenditures low. These factors create a compounding effect that increases the overall value,” he said.
Real Estate Valuation Methods
There are several methods to determine the best cap rate for a property. While the calculations have some complications, they’re essentially different ways of accounting for risk and the effects of market conditions. The three main methods are as follows:
- The build-up method: This starts with a basic rate and adds extra percentages for different types of risk, like how hard it might be to sell the property quickly.
- The market-extraction method: This looks at similar properties that have sold recently.
- The band-of-investment method: This accounts for both mortgage costs and cash investment returns.
Let’s look at each in more detail.
The Build-up Method
For this approach, you start with the interest rate and add the following:
- An appropriate liquidity premium: This accounts for the fact that real estate takes longer to sell than stocks or bonds.
- The recapture premium: The amount that covers how the land value might change.
- Risk premium: This covers the general risks in the real estate market.
For example, if you begin with a 6% interest rate and add 1.5% for a market where sales are slow, 1.5% for land value changes, and 2.5% for market risks, you’d get an 11.5% cap rate.
For a property earning $200,000 in yearly income after expenses, this would suggest a value of about $1.74 million ($200,000 ÷ 0.115).
While the calculation is straightforward, assessing how much to estimate for each part of the cap rate is less so.
The Market-Extraction Method
The market-extraction method uses similar properties that have recently sold in the area. This approach is particularly worthwhile since it works from real-world examples rather than theoretical calculations.
Let’s say you’re considering buying a parking lot that’s expected to earn $500,000 per year after expenses. To determine its value, you might look at three similar parking lots that sold recently:
- A lot earning $250,000 that sold for $3 million (8.33% cap rate)
- Another earning $400,000 that sold for $3.95 million (10.13% cap rate)
- A third earning $185,000 that sold for $2 million (9.25% cap rate)
Taking the average of these three cap rates (9.24%) suggests your parking lot is worth about $5.4 million ($500,000 ÷ 0.0924).
The Band-of-Investment Method
This method accounts for both the mortgage payment and the cash invested when determining the value. It’s more worthwhile if you plan to finance rather than pay for the property in cash.
You’ll first need to calculate the sinking fund factor (SFF), which is essentially the amount you need to set aside regularly to repay your loan. The math can look complicated (there are various calculators online and in spreadsheets to do the work for you), but it’s nothing more than computing a savings plan in reverse: How much do you need to put aside each year to have enough to pay off your loan?
For example, suppose that a property with an NOI of $950,000 is to be half-financed using debt at 7% interest to be amortized over 15 years, while the rest is paid with equity at a required rate of return of 10%. The sinking fund factor is calculated as follows:
SFF=(1+i)n−1iwhere:SFF=Sinking fund factori=Periodic interest rate, often expressed as ani=annual percentage raten=Number of periods, often expressed in years
Plugging in the numbers, we get the following:
0.07 ÷ (1 + 0.07)15 – 1
This works out to 3.98%. The rate at which a lender must be paid equals this sinking fund factor plus the interest rate. Here it’s 10.98% (0.07 + 0.0398).
Thus, the weighted average rate, or the overall capitalization rate, using the 50% weight for debt and 50% weight for equity, is as follows:
10.49% = (0.5 x 0.1098) + (0.5 x 0.10)
As a result, the market value of the property would be $9.06 million ($950,000 ÷ 0.1049).
Warning
Mortgage lending discrimination is illegal. If you think you’ve been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau or with the U.S. Department of Housing and Urban Development (HUD).
Absolute and Relative Valuation Methods
Just as stock investors use different methods to value companies, real estate investors have two main approaches for determining property values. Neither method is perfect on its own, which is why experienced investors often use both to get a more complete picture.
Discounting Future Net Operating Income (NOI)
The first method looks at how much income a property will generate over time. This approach, called discounting future NOI, is similar to how investors value dividend-paying stocks.
The formula for calculating real estate value based on discounted NOI is as follows:
Market Value=r−gNOI1=RNOI1where:NOI=Net operating incomer=Required rate of return on real estate assetsg=Growth rate of NOIR=Capitalization rate (r−g)
NOI reflects the property’s earnings after factoring in operating expenses but before taxes and interest payments are deducted. However, the total revenues gained from the investment must be determined before subtracting expenses.
Expected rental revenue can initially be based on comparable properties nearby. Performing some market research, you can determine the rent tenants are paying in the area and use the rental rate per square foot for the property you’re assessing. Expected increases in rents are accounted for by the growth rate in the formula.
Empty units can significantly impact your property’s income, so it’s important to be conservative in your estimates. Rather than assuming full occupancy, you’ll want to plan for some vacancies and calculate how different vacancy rates might affect your returns.
In addition, when calculating a property’s income, you’ll need to subtract everyday operating costs like the following:
- Insurance
- Property management fees
- Maintenance and repairs
- Utilities
These costs give you the NOI—what’s left after paying regular expenses but before considering loan payments, taxes, and depreciation.
Meijer warned that while you might be tempted to take on more debt to grow your potential returns, this can come back to haunt you should the market shift. “Having too much leverage is the same classic mistake being made again and again in real estate.”
Gross Income Multiplier
The second method, a relative valuation, compares properties to those that are similar in the area—much like a real estate agent will show you a range of homes in an area to get a sense of pricing there. This approach uses what’s called a gross income multiplier. Since it’s the gross figure, it’s the total income before deducting operating expenses.
For example, a real estate investor who purchases a 100,000-square-foot building may determine from comparison data that the average gross monthly income per square foot in the area is $10. An initial estimate for the gross income would be $12 million ($10 x 12 months x 100,000 sq. feet).
However, there are likely to be vacant units in the building at any given time. Assuming a 10% vacancy rate, the gross annual income would be $10.8 million ($12 million x 90%). A similar approach is applied when using the net operating income.
Meijer noted that the real estate market doesn’t offer you the same relatively easy access to information as the stock markets. Sales prices, rental rates, and operating costs can be hard to verify or even track down, making property research and real estate valuation a greater challenge.
Roadblocks to Real Estate Valuation
Both of these real estate valuation methods can seem relatively straightforward. However, in practice, determining the value of an income-generating property can be fairly complicated. First, it can be time-consuming and a challenge to get the information you need, whether it’s the estimated net operating income, the premiums included in the capitalization rate, or comparable sales data.
Second, these valuation models don’t account for possible shifts in the real estate market, such as a credit crisis or a real estate boom. As a result, you’ll need to do some further analysis to factor in the possible changes in the broader economy.
While this research can take a lot of time and effort, the rewards can be significant. Finding an undervalued property can lead to big profits, making the detailed analysis worth it.
What Is the Difference Between Market Value and Assessed Value in Real Estate?
Market value is the estimated price a seller would pay in the current market. The assessed value, which is used mostly in property tax contexts, is determined by local government assessors and may be lower than market value. While market value fluctuates with market conditions, assessed values typically change less frequently and may not reflect recent improvements made to the property or shifts in the market.
What Should Investors Focus on When Valuing Real Estate During a Downturn?
Meijer suggests looking for assets that are undervalued and have solid fundamentals to weather challenging times.“You want to ensure your valuations are ‘bulletproof’ during downturns. If [properties] are priced so low that they protect against further declines, you’ve found a good opportunity,” Meijer said.
Key considerations include location since properties in prime locations often recover faster; cash flow potential, ensuring the property can generate consistent rental income; and the financial health of the investment, such as low debt levels or favorable loan terms.
What Are Comparables in Real Estate?
Comparables, or comps, are similar properties located in the same area as a property that is up for sale. These properties allow sellers to estimate the value of their own home or investment property when they decide to put it up for sale.
The Bottom Line
Real estate valuation, despite being done with numbers and calculations, is as much an art as a science, requiring you to have both analytical skills and qualitative market knowledge. Successful valuation comes from careful research into local market conditions, the property’s characteristics, and economic trends. Unlike stock market analysis, where data is readily available, real estate investors often need to dig deeper and depend on their experience (or those of peers) to find reliable information about comparable properties, operating costs, and market trends.
That said, Meijer warns investors not to follow the crowd since many in the sector “just rely on what they’ve heard from others,” such as generalizations about certain types of properties, and haven’t updated their models in years. The effort this research requires often profits those willing to do it. Those who combine careful analysis with local market knowledge may find properties others have overlooked or incorrectly valued, leading to higher investment returns.
