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
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
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,
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
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
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