Lesson 1
What Is Value
Obviously, you will need to know how to
determine the value of a property while you are evaluating potential
selections, when you are ready to write an offer on one of them, and during
the contingency period after a deal has been made. We will look at the
subject now because we will need to value example properties in other RHOL
e-courses.
Fair Market Value
Fair Market Value is the most probable price
that a property should bring in a competitive and open market under all
conditions requisite to a fair sale with the buyer and the seller each is
acting prudently and knowledgeably and assuming that the price is not
affected by undue stimulus. Implicit in this definition is the
consummation of a sale as of a specified date and the passing of title from
seller to buyer under conditions whereby:
- Buyer and seller are typically motivated,
- Both parties are well informed or well advised and each acting in what
he considers his own best interest,
- A reasonable time is allowed in the open market,
- Payment is made in terms of cash in U.S. dollars or in terms of
financial arrangements comparable thereto, and
- The price represents the normal consideration for the property sold
unaffected by special or creative financing or sales concessions
(adjustments must be made for special or creative financing or sales
concessions)
Although Fair Market Value is the ideal
price that seller should receive, a buyer should pay, an appraiser should
determine, and a lender should base his loan decision on, determining this
value is not an exact science. There are many different approaches to
determining fair market value. Some of these methods are meant to be
used only for rough estimates, some are more accurate in certain markets and
for certain types of properties, and some are considered to be generally
accurate and are used by professional appraisers. A valuation is
always more an opinion than a fact.
Things Affecting Value
There are a variety of factors that affect
the value of an income producing property, including the following:
Current Income
Net Operating Income (NOI) is the amount of
money available for debt service, or as return on investment from income
producing real estate. To determine the NOI, first calculate the
Scheduled Gross Income. A single family home's income is usually
confined to gross collected rents and rent taxes collected on behalf of the
state, county and/or city. Multi-family housing usually earns
additional revenue from several other sources as well, including coin-op
laundry equipment, public phones, extra parking spaces, etc.
Commercial property usually earns yet additional income, including some or
all tenants' shares of various expenses. Retail property may even
include percentages of some or all tenant's gross or net incomes from
business conducted on their premises. From the total Scheduled Income,
deduct allowances for vacancy and uncollected rents to arrive at the Net
Income.
Next calculate all Operating Expenses,
including taxes, insurance, repairs and maintenance, and rent taxes.
Finally, subtract the Operating Expenses from the Net Income to arrive
at the property's Net Operating Income (NOI).
The primary factors that will always affect
return on investment is the Net Operating Income
and the amount of leverage you are able to achieve. Accordingly,
approaches to valuation that emphasize NOI usually provide the most reliable
indications of value for most income properties. If you are not yet
familiar with the leverage concept, you should spend a few minutes reviewing
our page on Leverage.
Potential Income
Talk to a real estate professional about
an income producing property and the very first words out of their mouth
will probably be about the potential to increase revenue by raising rents
and improving management practices. Unfortunately, they often want you to
factor tomorrow's pie in the sky into the price
you are willing to pay for the property today. What they tell you about
increasing revenue may be true, but most income property should sell for a
price based on the current NOI. Sometimes a property really does have
immediate upside potential, for example, because soon-to-expire leases are
well under market or some expense items can be significantly reduced through
better management. In such cases this potential can be taken into
account. However, the real upside for gain and profit income
properties usually comes over time as you get steady increases in rent and
market value due to inflation and improving markets, while your invested
capital and debt service remain the same and most operating expenses usually
increase only at the rate of inflation.
Physical Condition
A property that is a good candidate for
purchase often looks to be in bad condition. That's OK, if it has the "right
things wrong with it." Examples include needing paint,
sagging porch, bare bones landscaping, ugly wallpaper, or being dirty.
These "things wrong" are usually easily and relatively cheaply
fixed. Even seemingly major deficiencies such as plumbing, electrical,
a defective furnace or a bad roof, can be factored into the price you offer.
However, the "wrong things
wrong" such as tiny bedrooms, lack of closets, steep narrow
stairways, one bath, and most importantly, bad location, are not
usually economically corrected.
When considering condition, remember,
homeowners buy pretty, landlords should buy practical and based on the
property's potential.
Market Conditions
For an investor, the best buy, in
the best condition is worthless if the rental market is in the proverbial
toilet because the military base or a major employer recently closed.
If a property is vacant it has negative value to landlords. Market
value is important to a homeowner, but is only relevant to a real estate
investor in that it reflects the possible resale value, and the investor's
net worth on paper.
Economic Trends
When investing in real estate, one must also
be aware of economic trends, not only at the local level as in the previous
paragraph, but also at the regional, national, and even international
levels. The interplay of economic forces ripples in both
directions throughout all levels of the economy.
As is probably obvious, the value of real
property is directly related to population growth. Population growth
that outpaces new construction can put pressure on increasing property
values and, conversely, development that outpaces population growth can
result in stagnation of value or even declining values. The impact of
population growth, however, is dependent upon the purchasing power of the
new population. This is in turn dependent upon disposable income, not
just gross income. For example, the disposable income per family
determines the volume of retail buying which, in turn, determines the rent
that the merchants can afford to pay which determines the value of the
property occupied by the merchants.
Neighborhood
A real property is an integral part of its
neighborhood and is affected by the interplay of economic, social, physical,
and governmental forces. A neighborhood may be part of a city, town,
or village or it may be an entire community. Its character may be
residential, commercial, industrial, or agricultural. Many factors are
pertinent for analysis of neighborhoods, including population growth,
economic status, social interests, prestige, transportation, schools,
churches, employment opportunities, and business centers.
Neighborhoods are not fixed in
characteristics, but are always changing, some very slowly, some rapidly.
Because a property's value is affected by the shifts in environment
resulting from changes in the neighborhood, valuation of a property should
include the effects of the neighborhood and future neighborhood trends.
Available Terms
"OK, your price, my terms," is
a favorite quotation of professional real estate investors. If you can
buy with little or no money out of pocket, and the property has a positive
cash flow at the asking price, it may be time to stop negotiating. Any
return on an investment with no money down is rather large, isn't it?
The next best alternative for a typical investor is assumption of existing
financing, with perhaps a second mortgage taken back by the seller for all
or part of the difference. Unfortunately, it is difficult to purchase
a property with no money down these days at a price low enough to allow a
positive cash flow in most rental markets. Furthermore, most
loans now have enforceable "due-on-sale" clauses and, when
obtaining financing, expect to put 20 to 30 percent down. Financing is
covered in detail in various pages on our Web sites and will be covered in
our future Financing Income Property e-course.
Resale Value (market
value)
The price paid for every investment property
should not only be dependent on its NOI, but should also reflect the
probable liquidation price in the event of an emergency. Always make
your purchase of investment property as if you are going to sell it the very
next day, with your only loss being your buying and selling costs.
Structure the terms and financing for resale, with assumption guarantees
whenever possible.
Price vs. Value
Many new investors make
the mistake of buying "bargain" property for rental housing
- because that is what the
man on TV told them to do - without
understanding why tenants choose the location where they want to live and
the kind of home they want to rent. To get good tenants and minimize
management problems you must own decent, safe and affordable housing in
areas where people want to live. Schools, transportation, shopping,
churches, and jobs all affect the amount of rent a tenant will be willing to
pay to live in your property. And that determines the price that you
can pay for the property.
When investors buy a property just
because it is priced $10,000 to $20,000 below market value, they often learn
too late why it was priced so low. Don't get caught in the most common
mistake made by inexperienced investors and become so blinded by the
"good deal" you are about to make that you don't see the rest of
the story. The price you can pay for income property must be a factor
of the NOI that it will eventually produce and the resale value of the
investment if you need to liquidate.
If, however, you intend to put the investment
in your "Four F Portfolio" (find them, fix
them, flip them and forget them). This a term used by
investors who buy a property to fix it up for a quick resale. In this
case your criteria is totally dependent on a recent market analyses for that
kind of property in that location after rehabilitation is complete.
There are legitimate reasons for a decent
property to sell well below market. Divorce, death, and taxes can
motivate sellers to take a quick cash offer that they would never agree to
under normal conditions. The most common reason a seller can't get a
fair price for a property is inadequate professional marketing or deferred
maintenance that "turns off" potential buyers upon first view.
If you are buying income property, the
purchase price can even be relatively unimportant. What is important is (1)
the amount of money that it will take to make the property decent, safe,
sanitary and desirable to a good tenant, (2) the terms of the sale, and (3)
the market rent for that property in that neighborhood. Of
course, you still want the purchase price plus rehab costs to be no more
than market value.
Cost vs. Value
In a free market,
the cost of producing goods or services often has little or nothing to do
with its ultimate value. The current values of a painting by Renoir or
a rare stamp have no relationship to their original cost of production. The
analogy is particularly true in real estate where the three things that most
affect value are location, location and location. When a builder
targets a home buyer he must select a location that will add value to his
cost of construction in order to make a profit. A 1,200 sq. foot home
on a $30,000 lot will cost about $102,000. The finished product must have a
value higher than that for the developer to stay in business.
Fortunately people are usually willing to pay more for a home they like, in
a desirable location, than it actually costs to produce.
Income property is different in
that its value depends primarily on it current and future ability to produce
income.
What can you afford
Most real estate investors have a limit on
the cost of the property that they can buy, and, unless you're Donald Trump,
that limit is probably not in the billions of dollars. However, even
if you are Donald, you still have a limit.
There are several factors that affect that
limit. First, there is the amount of cash that you have available to
cover the down payment, loan costs, and escrow costs. However, even if
you buy the property with nothing down, zero loan costs and the seller
covers all escrow costs, there are still limits. One limit is usually
imposed by certain principles of economics. That is, the higher the
leverage the less the positive cash flow, even when there is no vacancy and
no deferred maintenance. Unless you manage to "steal" the
property because of special circumstances (e.g., distress sale), it is
likely that a zero-down purchase will have a significant negative cash flow.
While you might be able to cover a $200 per month negative cash flow from a
small single-family house purchased with no money down, few investors can or
want to cover the $10,000 monthly negative cash flow from a 30-suite office
building.
Another related limitation comes into play as
soon as you need financing from other than the seller. For a
residential property larger than a 4-plex and for most commercial
properties, lenders will loan only 70 to 75 percent of the value.
Furthermore, the lender will usually want to see that the buyer has 10 to 20
percent of his own money in the deal, so the seller's willingness to carry
25 to 30 percent will not usually allow you to buy with no money down.
So, the bottom line is that the maximum value
property that you can buy is limited to that for which you can afford the
down payment necessary to reduce financing to the level that the property
will produce at least a small positive cash flow or a negative cash flow
that you can carry with minimum risk until the property's Net Operating
Income increases sufficiently. While this varies with (1) the current
interest rate and financing costs, (2) the price you pay relative to gross
income, (3) the expenses relative to income, and (4) how much deferred
maintenance comes with the property, you can typically buy a property
costing in the range of 3 to 4 times the cash that you have available.
Valuation vs. Appraisal
We will purposely always use the term
"valuation" rather than the term "appraisal' when discussing
determination of value by the buyer or other laymen. We reserve the
term "appraisal" for the formal work and/or written document
prepared in accordance with industry standards by a professional who is
certified to provide valuation of properties for purposes of making
federally insured loans. The appraiser profession and appraisals are
discussed further in a later lesson.
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