"How to (Correctly) Value Real Estate..."

WOW!!

I received a ton of feedback on yesterday's post "Whose Profits Are They Anyway...?"

One of the best was from Scott who made the point that when looking at commercial deals, often the purchase price is based on projections of cash flow and that the Seller has the right to claim that the cash flow that is projected one year out from the sale date was cash flow that was really created by the seller and not the buyer, because during that first year the buyer is really "living off" the efforts of the Seller - Scott is Dead on Right on this point!

Nonetheless, this is an issue that both the Buyer and Seller sometimes get into heated discussions over, and underscores the importance of not only having some fundamental negotiating skills under your belt, but also clearly understanding how to value a property prior to making the jump from single family houses to commercial real estate investing.

What did concern me in some of the emails I received though is that there is still a lot of confusion out there as to how you value a property. I got lots of emails talking about "cap rates" and "GRM" [Gross Rent Multiplier] when talking specifically about valuing investments in single family houses - THIS CONCERNS ME GREATLY!

YOU DO NOT VALUE INVESTMENTS IN SINGLE FAMILY HOUSES THE SAME WAY YOU DO COMMERCIAL PROPERTIES>>>
BIG "NO NO!"

The best guard against paying too much is to make sure you understand the fundamentals for valuing the type of property you are putting under contract. Each of the basic "Real Estate Food Groups" has its own particulars for valuation based on one of three schools of thought:

Income Approach,
Replacement Costs and
Comps.

Each of the three is appropriate for one of each of the Four Food Groups: Residential, Commercial, Industrial, Retail. (As I have said before on many occassions: LAND IS NOT FOOD GROUP!! <- But more on Land in a future post]

For today, let's tackle just one of the members of the Food Group; RESIDENTIAL,

Residential can be divided into two groups: 1-4 units (in the property) and Greater than 5 units (in a property). 1-4's would include single-family houses (both row homes and detached) as well as duplexes, tri-plexes and four-plexes and individual condo units. Although banks and lenders will look at several different ways to value a property (to make sure they are not lending "too much") there is only one appropriate method for an investor to value a Residential (1-4 unit) investment and that is by looking at market comps. Comps, as in recently COMPLETED sales of units of a similar size, quality and amenities package located within close proximity.

And the single most important step in running comps is to accurately determine what is the neighborhood in which the property resides. A task that is a little more involved than it may first appear. Specifically, answering the question: "what is the neighborhood" 9 times out of 10 means being familiar enough to know when one neighborhood ends and another begins. In a condo project it is relatively easy - the total collection of condos is "the neighborhood", in a suburban subdivision with 500-800 houses all built by a small handful of builders from 3-4 basic plans, all constructed within 3-5 years of each other, the subdivision is the neighborhood. However, when you get into urban situations, the neighborhood can change "block by block". in most cases knowing the neighborhood means getting in a car (or in some cases getting out of the car) and looking with a notebook and map under arm. Making notes as to what streets, or rail lines , or water features define when one neighborhood ends and another begins.

Since 85% of the value of any single family home is derived from the neighborhood it sits in, "knowing the neighborhood" is a critical step. Many national "gurus" will gloss over this key item - As my mother use to say to my sister and I after watching our "umpteenth" episode of I LOVE LUCY, "Lucy has her money - you got your's to get!"

THE NATIONAL GURU's HAVE THEIR MONEY - YOU HAVE YOURS TO GET! You can not "gloss over anything" at this stage of your investing.

Understanding the proper method for determining value and then USING IT, is a critical step in building a solid foundation as an investor.