In the words of many savvy real estate investors,
“You make money when you buy a property not when you sell.”
But when investing in notes we are not buying the property itself. Rather we are purchasing the right to receive the remaining payments. However, the note payments are secured by a lien on the real estate. If things go South and the payer stops making payments then you’ll end up with the property.
Whether buying real estate or investing in notes, it’s crucial to know the current market value of the property.
Many mistakenly believe that the sales price and the market value are always the same thing. A fair market value is the price an informed buyer and seller, not acting under duress, would agree upon for the sale of property.
So, how do we accurately estimate a property’s fair market value?
There are three generally accepted methods to estimating value.
- The sales comparison approach estimates a property’s value by comparing it to similar properties that recently sold in the area making adjustments for differences.
- The income approach values a property based on its potential for rental or lease income.
- While the cost approach is based on cost to replace the property.
These approaches to value are used by professional appraisals and will be explained in greater detail.
The “No Cost” Approach
There are a variety of simple methods that can be used as initial estimating tools during the quoting process. The first is to access the county records. These are open to the public and can be viewed online or by a visit to the local county tax assessor’s office. In addition to viewing the assessed value of the subject property, you can also search for the recent sale price of similar nearby properties.
Keep in mind that county tax assessed values may not accurately represent the current fair market value. Oftentimes, tax assessed values are lower than market values. In some counties, this is by design as they have a formula or percentage of tax assessed value to fair market value. In other cases, a property might have a low assessed value due to an extensive amount of time since the last value review or reassessment.
You can also look to an online estimator for an approximate value. These sites use recent sales data and county records to estimate a property value. There are a variety of popular sites including www.zillow.com, www.trulia.com, www.housevalues.com, and www.free-home-appraisal.com. Keep in mind that not all sites are created equal plus they may not accurately reflect recent shifts in a market.
A seasoned real estate agent can be a good resource for estimating value in light of current market trends. A real estate agent is often willing to provide a comprehensive Comparative Market Analysis (CMA) for your property in hopes of obtaining a listing or future business.
As the saying goes, you get what you pay for so most note investors are going to require the services of a paid professional in the form of an appraisal or BPO as part of the due diligence process before funding.
Broker’s Price Opinion or BPOs
The BPO is where a real estate broker is hired to provide an opinion of value on the property for pricing purposes. In some states real estate agents or brokers are not approved to issue BPOs so they are performed by a licensed appraiser.
Generally a BPO Report is 2-5 pages long and less comprehensive than a full appraisal. BPO prices average between $50-$150 depending on if it’s a drive-by, interior, review, or inspection of property condition. A BPO is often used in short sales, foreclosures, private sales, and by some note investors.
The Professional Real Estate Appraiser Value
The services of a professional appraiser are typically employed for a more accurate opinion of value. Their fees for a residential property average $275-$400, with higher fees for commercial or income producing properties. In order to become licensed by their state, an appraiser must complete a certification process including testing, class hours, and apprentice experience. Federally regulated lenders require appraisals to be completed by licensed appraisers in accordance with the Uniform Standards of Professional Appraisal Practice (USPAP).
An appraiser will inspect the property and analyze the market, collecting specific information on the property along with similar properties in the area. To reach the final value, an appraiser will use one or more of the three commonly accepted methods of estimating value. By understanding how an appraiser utilizes each method it is possible to accurately estimate a property’s value.
Sales Comparison Approach
The sales comparison approach estimates a property’s value by comparing it to similar properties that recently sold in the area. Those properties are called comparables, or “comps.” The sales approach is generally used to appraise all property types and is the method most relied upon for residential properties.
A minimum of three comparable properties are selected based on their similarities, with careful consideration given to:
- Size or Square Footage
- Room Type and Count
- Date of Sale
- Type of Financing Used
- Style and Construction
- Special Features (view, pool, fireplace, fence, etc.)
- Lot Size
Ideally, the comparable properties would be identical. Since this is rarely the case, adjustments are made by adding or subtracting the amount of any differences between the properties to or from the value of the comparable property.
To illustrate, consider two homes, with House A being the subject property and House B being the comparable home that sold recently for $176,000. Upon comparing the two properties, the only major difference found is that House B has a pool valued at $6,500, while House A does not have a pool. In order to make an adjustment for the difference, the $6,500 pool value is subtracted from the $176,000 sale price of House B to arrive at an adjusted comparable sales price of $169,500.
The appraiser makes this type of adjustment either up or down for all major differences on each comparable. The standard appraisal form 1004 utilized by most residential appraisers lists at least 18 items for possible adjustments with additional lines for out of the ordinary considerations.
One adjustment category that deserves a closer look in the world of seller financing is “Sales or Financing Concessions.” The determination of fair market value requires financing on terms typically available in the market. Seller financing or other favorable terms are often considered a financing concession resulting in a premium or higher price. If the subject property had seller financing and the comparables did not, an adjustment might be made accordingly.
A simpler, layman’s approach to estimating a sales comparison value is to locate three similar properties and divide the sale price by the square footage to arrive at an average price per square foot.
Sales Comparison Example
|House 1||House 2||House 3|
|÷ Square Feet||1,625||1,837||1,575|
|Price Per Sq. Ft.||$102||$97||$109|
The range of price per square foot is $97-$109 with an average of $102.67. If the subject property contained 1,765 square feet the value could be estimated at $181,213 (1,765 x 102.67). This serves only as a ballpark estimate and does not come close to approximating the detail of the thorough adjustment analysis provided in an appraisal.
The cost approach is based on the current cost to replace the property improvements and is useful in determining insurable value. The cost approach takes into consideration:
An estimate of the land value
A cost estimate of replacing the buildings new at current building rates
Depreciation (wear and tear) on the building, including physical, functional, and external
As-is value of site improvements
Equals (=) Value by Cost Approach
The income approach is used to formulate a value based on the potential for rental income. It is generally used in combination with the sales and cost approaches to indicate value on commercial properties, apartment buildings, rental properties, and other income producing properties.
The simplest way to calculate the income approach to value is utilizing the Gross Rent Multiplier (GRM). In order to calculate GRM it is necessary to know the sale price and monthly rental income of similar properties. The sale price is divided by the monthly (or annual) rent to obtain the GRM as follows:
Calculating GRM Example
|House 1||House 2||House 3|
|÷ Monthly Rent||1,500||1,750||1,600|
When an average GRM is known on similar rental properties, then a value can be determined using the monthly (or annual) rental income times the GRM. If the income potential on a home is $1,675 per month, the estimated income approach value is calculated as follows:
Income Approach Example (GRM)
The range of value is $170,850 to $184,250, with the average being $178,108. This simplified method is most often used on residential rental properties and it does not take into account vacancy rates or expenses.
The income capitalization rate is a more reliable tool for estimating value on income properties, as it factors in both expenses and vacancy rates. The use of a “cap rate” is based on the expectation of future benefits (anticipated income) and what that is worth today (property market value).
An appraiser will select a minimum of three comparable income-producing properties and analyze their sale price in relation to their Net Operating Income to determine the cap rate. The cap rate is calculated by taking the annual net operating income (NOI) divided by the sale price as follows:
Cap Rate Example
|Sale 1||Sale 2||Sale 3|
|÷ Sales Price||$275,500||$360,000||$250,000|
From this data, the appraiser will determine which cap rate to utilize for estimating value on the property being valued, which in this example is a 10 percent cap rate. The annual net operating income is then calculated on the subject property based on potential income less all expenses including vacancy and collection losses, property taxes, insurance, replacement reserves, and operating expenses (utilities, advertising, maintenance, etc).
If the property being valued had an annual net operating income of $30,656 and similar properties sold were producing cap rates in the 10 percent range, then the value can be estimated at $306,560 ($30,656 divided by .10 = $306,560).
Using Value To Calculate LTV and ITV
Once a fair market evaluation has been provided most investors will review the appraiser for accuracy. This value will then be used to calculate the current LTV and ITV.
If a property value is lower than the sales price it is very likely that a note investor will adjust their initial offer. Why? Well lower values create higher LTVs and ITVs which can increase the risk.
Let’s say an investor had quoted a deal assuming a 70% ITV based on a sales price of $165,000. That would bring the maximum pay price based on ITV to $115,500.
If the property is now worth $150,000 then the maximum a note buyer could invest and maintain a 70 ITV would now be $105,000. That’s potentially a $10,500 difference!
To accurately determine a property’s value it is not enough to just know the sale price of similar properties. In addition to verifying property data and current sales trends you must know if the buyer and seller had full knowledge of the market, bought or sold in a hurry, provided out of the ordinary financing terms, or any other concessions that might have influenced the price. By utilizing and understanding the sales comparison, income, and cost approaches to value it is possible to estimate the fair market value, making money when you both buy and sell a property or real estate notes.