Before an investor can feel comfortable committing their hard-earned money to a property, they must first determine their return on investment. Without that knowledge, there’s no level of safety or security—knowing the cost is one thing, but figuring out the value is something else entirely. Read on to learn our complete guide to investment property appraisals.
Do You Need To Appraise?
The short answer is no—you don’t need to appraise a property before you buy it. However, if you don’t, you may leave money on the table with every investment you make. There’s no reason not to appraise a property, unless you don’t want to get the best bang for your buck. Knowledge is power and understanding the potential return on investment (ROI) is your best bet to make smart decisions with your money.
Additionally, there are more times to appraise than the pre-buying stage. Appraisals are great for determining how much a property has appreciated or depreciated—while one is less ideal than another, it’s essential information for an investor to have. Even if you receive the bad news that a property is depreciating, there’s a silver lining: you can save money on taxes since the property value isn’t as high.
The cost of an appraisal varies depending on your area and the stage you’re in with a given property. You may pay a few hundred dollars for an appraisal at closing, or you may pay more if you want an investment property appraised.
Appraisal vs. Valuation
We keep using the word “appraisal,” but you may have also heard the term “valuation.” While many people believe these are synonyms, they don’t describe the same process.
An appraisal is not a definitive value of a property. Instead, you get an appraisal from a real estate professional that tells you the approximate value of a property. It gives you a good sense of what a property is worth, but the true value may be slightly higher or lower.
On the other hand, a valuation does give you the “true value” of a property. A valuer with formal training conducts a rigorous process to arrive at the exact value of a property, taking into account all factors, from the structure’s condition to zoning to accessibility. This valuation is crucial if you want to settle a property dispute in court.
Sales Comparison Approach (SCA)
The question remains: how do real estate professionals conduct their appraisal process to give you the approximate value of a property? One method is the sales comparison approach, or SCA. This is perhaps the most widely used form of appraising and valuating.
This approach is straightforward—the appraiser compares the property to similar ones that have been sold or rented in the area over a certain period. This is an excellent way to show investors a comparison over time to determine emerging trends.
The appraiser looks at attributes and features that the property shares with others sold—in the case of a residential property, this could include the number of bedrooms, bathrooms, garages, or driveways. If there’s an element that makes a property noteworthy, it will be compared to other nearby homes.
As a general rule, price per square foot is a reliable go-to metric. If you have a 1,500-square-foot townhouse for rent and there’s another just like it down the street, learn their price per square foot to arrive at a ballpark of the price you can ask for your rental.
Capital Asset Pricing Model (CAPM)
If you want a more comprehensive idea of a property’s value, the capital asset pricing model (CAPM) adds risk and opportunity cost to the picture. This model analyzes the potential ROI from a rental property and looks at other investments with little to no risk, like real estate investment trusts or U.S. Treasury Bonds.
At the end of the day, if the potential ROI of a rental property is lower than that of a risk-free investment, there’s no reason to take a risk.
Risk Factors
You may be thinking, “What are the risks of rental properties?” While they aren’t abundant, there are a few things you should consider before signing any papers. For one thing, not all properties are created equal. A good property in a bad location may not get you the return you’re hoping for, and older properties tend to come with higher maintenance costs.
Additionally, you’ll need to account for insurance and other safety precautions if your property is in an area with a lot of crime. The CAPM helps you figure out whether the risk is worth the potential reward, and an investment property management company can guide you through the risks to enjoy a sizable return on your investment.
Income Approach
If you’re thinking about investing in commercial real estate, the income approach may be for you. This approach looks at the potential income of a property compared to the initial investment.
First, you must determine the annual capitalization rate for your investment. You figure out this number by dividing your gross rent multiplier by the current property value. In other words, if an office building costs $220,000 to purchase and your expected monthly income is $2,200, then the expected yearly capitalization rate is $26,400 ($2,200 x 12 months) ÷ $220,000 = 0.12, or 12 percent.
Gross Rent Multiplier Approach (GRM)
The gross rent multiplier approach (GRM) is a quick and easy way to see if a property is worth your investment. This approach values a given property on the rent you can collect each year. This approach does not factor in taxes, utilities, or insurance, so use it for what it is: a fast way to see what a property can do for you.
This is similar to the income approach but removes operating income as its cap rate—instead, the cap rate is your gross rent. Look at the GRM and rental income of other properties like the one you’re interested in for the best comparison.
Now that you know this complete guide to investment property appraisals, determine the value of your next investment before you throw money at it—this can make you much more successful in the long run!
