The most common mistake that many beginning real estate investors make
is that they pay too much for property. Fact is overpaying for property
is often cited as the number one reason why so many newcomers fail to
make it as profitable real estate investors. That's because most
beginning real estate investors are woefully undercapitalized, and they
don't have the deep pockets that are needed to subsidize their
overpriced
real estate investments.
For many neophyte investors, paying too much for their
first investment property
usually proves to be a very costly and fatal mistake, and marks the
beginning of the end of their foray into real estate. That's why it's
imperative that you learn how to accurately estimate the current market
value of potential investment properties! As far as I'm concerned, it's
the single most important aspect of the entire real estate investment
business!
A Fast $15,000 Profit for Knowing the Value of a Condemned House
I once bought a real estate option on a filthy, neglected, run-down, but structurally sound
house in a neighborhood-in-transition in Winter Park,
Florida, a suburb of Orlando, that had been condemned for building,
safety, health and fire code violations. This place looked like
something right out of downtown Baghdad, Iraq! It had what code
enforcement inspectors commonly refer to as accumulations of every type
of debris, garbage and junk known to mankind! The property's owner lived
in Westerville, Ohio, and wanted the steady stream of threatening
letters from the Winter Park Code Enforcement Board to stop.
I
had done my homework, and knew the property was worth at least $110,000
after it was cleaned up. I ended up paying $500 for a one-year option to
purchase the house for $75,000. It cost me $2000 to have all of the
accumulations removed from the property, and the house, driveway and
walkways pressure washed. Three weeks later, I sold my real estate
option agreement for a $15,000 profit! This never would have happened if
I had been clueless about how to
estimate property values.
Since I had an accurate estimate as to how much the property was worth
in its current condition, I was able to negotiate a below market
purchase price that was based on the property's filthy, neglected,
run-down non-marketable condition, and not on how much it might have
been worth after it had been cleaned up.
records are available online.
The Definition of Market Value
The
Appraisal Foundation's Uniform Standards of Professional Appraisal
Practice, defines market value as: "The most probable price a property
should bring in a competitive and open market under all conditions
requisite to a fair sale, the buyer and seller each acting prudently and
knowledgeably, and assuming the sale price isn't affected by undue
stimulus.”
The Difference Between Assessed Value and Appraised Value
The difference between a property's tax-assessed value and its appraised value is as follows:
1.
Tax Assessed Value: Tax-assessed value is the value established by the
local taxing authority for a parcel of land and the improvements placed
upon the land for property tax purposes. For example, in Florida,
owner-occupied single-family houses are generally assessed at around
seventy percent of their fair market value by county property
appraisers.
2. Appraised Value: Appraised value is the value
estimate given to a property by a licensed property appraiser using
accepted appraisal methods for the type of property being appraised. For
example, the accepted appraisal method to accurately estimate the fair
market value for an owner-occupied single-family house is the comparison
sales method where a property's value is based on the recent sale of
comparable properties within the same area.
The Three Common Methods Used to Estimate Property Values
The three most common methods used by property appraisers to estimate property values are the:
1.
Comparison Sales Method: The comparison sales method bases a property's
value on the recent sale prices of properties that are within the same
area and comparable in size, quality, amenities and features.
2.
Income Method: The income method is used to estimate the value of an
income producing property based on the net income the property produces.
3.
Replacement Cost Method: The replacement cost method is based on what
it would cost to replace the improvements on property using similar
construction materials and construction methods.
The Comparison Sales Method of Estimating a Property's Value
The
comparison sales method of estimating a property's value is based on
the recent sale prices of properties within the same area that are
comparable in size, amenities and features. In order to be accurate,
sale price adjustments must be made for comparable properties that have
been sold at unrealistically low prices or on overly favorable financial
terms not readily available to the buying public.
The Income Method of Estimating a Property's Value
The
income method is used to estimate the value of an income producing
property based on the net income the property produces. Under the income
method value is calculated using a:
1. Capitalization Rate. The
capitalization rate, or cap rate, is calculated by dividing a property's
annual net operating income by its purchase price.
2. Gross Rent
Multiplier. The gross rent multiplier, or GRM, is calculated by
dividing the purchase price by the property's monthly gross operating
income.
Watch Out for Owners Using Fuzzy Math
A word to
the wise: when you read a property's income and expense statement, you
should always go under the assumption that the owner is probably
practicing fuzzy math by fudging on the numbers, and telling little
white lies to back them up. Also, use a monthly income and expense
analysis worksheet like the sample copy below, to cross-check everything
that's listed on a property's income and expense statement in order to
reconcile the statement with receipts and tax returns against what's
shown on:
1. Schedule E (Supplemental Income and Loss) of the owner's latest federal income tax return.
2.
The property's latest annual tax assessment income and expense
statement on file at the county property appraiser or assessor's office.
3. All of the rental agreements for the past year.
4. Water, sewage, solid waste, gas and electric bills for the past year.
5. Repair and capital improvement bills for the past year.
The Replacement Cost Method of Estimating a Property's Value
The
replacement cost method of estimating a property's value is based on
the cost of replacing the improvements on the property minus the cost of
the land to estimate a property's value. Replacement costs are
calculated on a per square foot basis by dividing the total number of
square feet in the
building by the per square foot construction cost.
For example, a two thousand square foot convenience store that cost
$375,000 to build would have a replacement cost of $187.50 per square
foot, $375,000 divided by 2000.
