August 08, 2007

3 Methods of Real Estate Valuation for Wonderland Housing: The Cost, Sales Comparison, and Income Capitalization Approaches.


You may be wondering how appraisers arrive at a market value for a home. In case you haven’t noticed in overpriced metro areas, we’ve been using the unconventional approach of flying by the seat of your pants. This phrase comes from the early days of aviation when pilots had few flight control systems and navigational aids; no GPS and flight towers for these folks. These pilots flew by intuition and experience, sort of like our modern day appraisers. After all, at the heart of speculation is going with your “gut” and making a big profit in a shorter time frame. Speculating in any bubble can be lucrative; as long as there is a greater fool that you can find to pass on your valuable commodity you'll make money. Once this perception breaks, the market hits a free fall mode and panic ensues. In our current housing and credit market, this doesn’t mean that homes will drop to zero and you’ll be able to go to your local bank with your American Express card to buy a REO home. Real estate does have a value. In fact, there are a few methods to calculate a market value that is based on fundamentals. These haven’t been used in a balanced approach in California, but they will come back as most things revert to the mean over time. The 3 approaches for real estate valuation we will examine in this article are the cost, sales comparison, and income capitalization approaches.

The Cost Approach

The cost approach factors in the price of the land plus construction, material, labor, and all other costs to replicate the home at current market rates. This approach doesn’t bode well for selling residential property because you can find land in North Dakota for dirt cheap (literally) and find that building a home there is cheap. So you build a home but what is the market for other homes? How is the employment base? Will someone give you a mortgage for a property? This method is generally more applicable to builders who try to ascertain the price per property for a project and find a break even point for profit. This approach is also used in special works projects since this may be the only approach that can reflect a realistic price range (i.e., a parking lot).

This approach requires first a value of the land if it was vacant and put to “best use.” In California that means dolling it up and flipping it in 0 to 60 in five seconds or less. Next, there needs to be an assessment of the replacement cost at current market rates for materials and labor. You factor in depreciation and reevaluate your other items including land and replacement cost and you should arrive at your cost approach value. Rarely do appraisers in the single family market use this approach. So what have they been using?

The Sales Comparison Approach v2.0

Location, location, location. We’ve all heard that real estate mantra. Here in California, we’ve been living in a Ponzi Scheme Mortgage Charged Sales Comparison Approach v2.0 mode these last few years. The sales comparison method is great in valuing housing in stable markets because for the most part, it’ll give you an accurate reflection of the current market of your local real estate. Again, that is if the market is stable. But what happens when prices go into bubblelista territory? If 2 homes sold, 1 that is 1,000 square feet and the other 1,500 square feet, for $200,000 and $300,000 respectively in the same area you can easily derive a value for a similar home that is 1,250 feet. First we figure that the square foot price for the previous two homes is $200. We simply multiply this with the current home, 1250 x $200 and this gives us a price of $250,000. Then you need to adjust for additional factors such as upgrades, the lovely granite countertops, nice shiny chrome faucets, and other positives or negatives. This basic approach, in theory, should give you a general idea of the current market price. Think of buying fruit or produce at your local supermarket. Not all apples are created the same but share very similar characteristics so you buy them by weight. You take a look at the red texture, give it a few taps, and pay per/pound. Is a mutant apple worth more simply because it weighs 5 pounds? In fact, you'll notice scales of economy on certain homes that are too big. That is, you may find the price per foot gets cheaper for super large McMansions.

But what happens when everyone is overpricing their home? Welcome to the sales comparison v2.0 bubble. Say the 2 homes above now sold for, $300,000 and $450,000 a year later, and nothing intrinsically has changed within the home. By the sales comparison approach, our current home is now “worth” a lot more. In fact, our square foot price went from $200 to $300, a 50 percent increase. This is great for anyone in the area because this inflates all homes in the immediate area. Yet you can see the fallacy in using only one approach.

If you were to factor in the cost approach as well, for example getting a true replacement value of the granite countertops and faucets, you may realize the home is only worth more by $10,000. Even if you factor inflation, you would realize that something is going on here. This type of rapid paced housing inflation has no economic fundamental sense. We are also seeing greater transparency in the industry. You can log into Zillow and find average square foot prices from recent sales in your local area. You can also use Google Earth to scout the area. Does your neighbor have a pool? Are you behind a restaurant or freeway? What is the average commute time to your work place? Maybe you are located near fantastic schools, which you can search again via free sources. These are the "intangibles" of setting a price. In a way, you become the future appraiser. There are other items that trained appraisers provide which go beyond this scope, but there is no reason for you not to have a thorough understanding of why the home you are buying or selling is worth the current price. Back to the current market, the reason so many people stayed [are staying] in denial is because they simply relied 100 percent on the sales comparison mode without factoring area income, intangible factors, cost approach methods, or even looking at the potential income of the property.

The Income Capitalization Approach

As I discussed in a previous article, Los Angeles County is a majority renting county. In fact, homeownership in California hovers around 57 percent, a far cry from the 70 percent of the overall nation. This means that a lot of people are landlords and renters. Most people do not invest money expecting a loss of their capital. It has become an act of futility to try to find an income producing property in the entire state of California. The income approach is used by real estate investors predominantly to arrive at a market price for a property. This is useful in evaluating multi-unit properties because you may not have many sales comparisons of 36 unit apartment buildings in the area. And zoning regulations may void the cost approach altogether. So you need another method of figuring out the value of the place. Let us use an example of a 4 unit property.

First, you need to determine the net operating income. In this case it is:

(Property gross income) – (All expenses excluding the loan payments) = NOI

Say the 4 units bring in $48,000 per year and the expenses amount to $21,600 (a 45 percent expense ratio which most seasoned investors rely heavily upon). So your net operating income is $26,400 per year. What do you do with this number? Well, most investors research the local market and try to find the prevailing expected rate of return for the area. This leads us into the capitalization rate of a home. The “cap rate” gives us a better understanding of what local investors are returning on their investments. Let us say that the area has a cap rate of 7 percent. To find an underlying value of this potential property we use the following information:

$26,400 divided by .07 = $377,143

So if we are expecting a cap rate of 7 percent the maximum amount we should pay for the property is approximately $377,143. Many in the housing industry will say these numbers mean nothing in California or any overpriced markets because land is volatile here and heck, we have the sunshine tax. Sun only hits the west coast, didn't you hear? Maybe the numbers from the income approach have little reflection on the price, but using 3 methods provides triangulation of multiple perspectives and will give you a better overall picture of the value of the home. It might even save you should you need to sell immediately.

The sales comparison approach will always be the prevailing method of valuation for the single family residential market. The various methods should be used in conjunction to give you a better overall picture of the market. Many people in California were buying “investment properties” with 2/28 loans going negative cash flow because in their mind’s eye, they didn’t care about the $700 to $1,000 loss each month because they were going to flip the property next year for $100,000 more. This worked for a few years but now you are seeing what happens when you rely too heavily on one method for investing. These folks are trying to unload their properties in a market that is saturated and any investor that has some basic knowledge of investing will never pay the current market rate. They’ll be negative cash flowing from here to Canada. Current buyers are looking at recent sales and see numbers dropping and appreciation at zero or even worse, negative. So they stay out. Plus you have brave souls still being brought into the shenanigans of the market but the credit markets are dry and actually checking income statements! The audacity. And then you have sellers trying to unload properties that are simply overpriced by any form of valuation except the flying by the seat of your pants approach. Welcome to the slow decline of housing.

Related Posts:

Why the Housing Market Has Failed You. 5 Major Failures of the Housing Market

Housing and the age of Affluence: Transforming the Definition of Income and Wealth

Comparative Analysis of 3 U.S. Cities: Contrary to What Your Parents Told You, Not all Bubbles are Created Equally.



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4 Comments:

Jim in San Marcos said...

Hi Doc

Good read.

A faster easier way to compute the estimated value of a rental is to take the monthly rent and multiply by 100 (It just involves less math).

The second step to realize, never sell rental real estate. Leave it to your kids and avoid the taxes.

Hiphopapotamus said...

i agree in principle, but in this market i just don't want to hold onto real estate in california. i just sold a rental in 29 palms that i've had for 3 years. it was cash flow positive and i hated to give it up but i sold it for triple what i paid for it. a few hundred dollars a month profit over 30 years just can't compare to nearly $100K right now, even with the taxes, imho.

mikey said...

gee, scarecrow, I think I'll miss Tanya Memme most of all...wait, maybe she could host a reality show where she rides along with the marshal during evictions?

John said...

What about estimating home value by finding what comparable homes are renting for and using a multiple of that -- I recall reading 120 to 180, depending on the market (i.e., a good price thumbrule is that the cost of a house is monthly rental value x N, where N is between 120 and 180).

Seems like that has been a fairly good crosscheck on the other methods at times ...