Comparable Sales

With real estate, as with most other asset classes, the key to valuing a property is to look at the most recent comparable sales (“comps”). However, because each property tends to be unique and there are so many factors to consider, it requires a lot of research and educated guesswork to pin down a value. It is not enough to evaluate a 3-bedroom house by just looking at sales of 3-bedroom houses in the same neighborhood - you have to know the quality of the interior, the square footage, the outdoor space, the taxes, the mechanicals (heating, plumbing, electrical) and many other factors. Look at as many potential comps and try to understand the differences between the properties and between the locations that account for the difference in value.

Cap Rate

In evaluating investment properties, figuring out potential cash flow is the key to valuation. The two metrics that most investors look at are the cash-on-cash rate and the capitalization rate (“cap rate”). Cap rate is calculated by taking the net operating income (“NOI”), which is the rental income minus all expenses, divided by the purchase price - so, if the NOI for a property is $100,000 and the price is $2,000,000, the cap rate would be 5%. For a property paid for in all cash, the cash-on-cash rate (net proceeds compared to cash invested) is the same as the cap rate - it’s only when a property is financed that the two metrics are different. There, you take the cash invested and compare it to the NOI including the mortgage costs. For example, if the cash invested into a property was $500,000, the NOI is $100,000 and the mortgage costs are $80,000, the cash flow would be $20,000 ($100,000-$80,000) and the cash on cash would be 4% ($20,000/$500,000).

Cap rate is a useful tool to compare properties in the absence of financing, as different terms for different loans can affect the potential cash on cash and ROI of a property. Stripping that away gives a more apples-to-apples comparison and is a way to compare buildings with different unit counts and different amenities. For example, evaluating a 40-unit building could be difficult if there are no other 40-unit buildings in the area, but knowing that buildings in a given area tend to average a 5% cap rate makes it possible to do so. It can also give investors an idea of the difference in cap rates between neighborhoods and cities, with more stable areas tending to have lower cap rates as investors are willing to take a lower return in exchange for lower risk. Properties that advertise higher cap rates are more likely to be in lower graded neighborhoods or cities with less chance for appreciation.

Because pricing properties based on cap rates is only possible with an accurate gauge of rental income and expenses, it is absolutely necessary to figure out taxes, insurance costs, utility costs, potential maintenance and capital expenditure costs as accurately as possible. There are no shortcuts here and no real way to try and evaluate properties on a larger scale - you have to be willing to do the work on each individual property. There is a reason that Zillow failed in their effort to build a home flipping business around their flawed Zestimate - “Fundamentally, we have been unable to predict future pricing of homes to a level of accuracy that makes this a safe business to be in,” Zillow CEO Rich Barton said. Be wary of any hard and fast rules around valuing a property that you see out there.

Cap rate is not the be-all, end-all, and it is important to dig as deep as possible when researching an individual property. Look to see if there are ways to “force” appreciation by improving a property’s NOI - generating more rental income or ancillary income (charging for storage, for example) and reducing expenses (weatherproofing to save on energy bills, for example). Research appreciation rates for specific neighborhoods and the local market for the property being evaluated.

Conclusion

Funds and principals soliciting investments tend to present optimistic views of potential cap rates, cash-on-cash rates and appreciation. Do your own research into the properties being offered to see how accurate their projections are. The biggest factor for whether you will make money on a real estate investment is the acquisition price - make sure to consider worst case scenarios for both cash flow and appreciation to see if a property is still worth it.