Investors, lenders, property tax assessors and others in the real estate industry are often looking to find the market value of property. This is the price that one can expect a property to sell for in the current market. If everyone had access to perfect information, all parties would come up with the same value for a given piece of property.
In the real estate market, however, most transactions are done among private parties, making it difficult to access good information. Contrast that with the stock market, where public companies disclose financial information on a quarterly basis. The lack of available financials and limited access to sale prices make it impossible for anyone to nail down an exact market value. Even appraisers, with extensive training and the time to conduct research, are able to make only estimates of market value.
Throughout this website, we cover the most commonly used approaches for valuing investment property. Most believe there should be a relationship between income-producing power and price. The income capitalization approach is often used to quantify that relationship, most often through direct capitalization calculated as NOI over a cap rate.
When information about comparable sales is unavailable, or when cash flows are expected to be uneven during a holding period, investors may also want to compute the present value of the expected future cash flows using discounted cash flow (DCF) analysis.
Another common way to value property is to use a multiple of gross potential rent, arrived at by observing multiples at comparable properties that sold. This is done with a gross rent multiplier (GRM) or a gross income multiplier (GIM), which are essentially the same. When using these multipliers, you should know whether they were derived from multiples of gross potential rent or effective gross income. This website determines GRMs by comparing price to gross potential rent.
Most valuation approaches rely on obtaining NOI and price information from comparable properties. This is true for direct capitalization and GRMs. Even DCF requires a cap rate estimate to project sale proceeds in the final year of the holding period. In this way, all of these approaches are relative value methods, similar to what stock investors employ when they compare and value companies using earnings multiples.
Among the most important tasks an investor has is to make an accurate projection of the expected costs to operate the project. The cap rate calculation tool on this website can be an invaluable resource for investors in that it gives an estimate of operating expenses broken down by line item based upon data collected from comparable properties.
A prudent investor should try to determine market value using several methods. An investor might use direct capitalization, DCF analysis and GIMs, for example, and take an average of the three resulting values.
Along with determining market value, investors should figure out "investment value." This is the amount an asset is worth to you. The best way to compute it is by using DCF analysis. This involves making a forecast of your expected cash flows over your projected holding period, selecting an appropriate discount rate (after considering alternative investment options available in the capital markets) and then coming up with the present value of those cash flows.
In an ideal situation, your investment value is higher than the market value. In these cases, it can be relatively easy for a buyer and seller to make a deal. For example, suppose an owner has an existing property and is trying to determine the value of a second property located across the street. The investor figures out that it can operate the second property for less than another buyer, because it can use the staff at the existing property to handle leasing at the second property. In this case, the investment value may be higher than the market value.
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