Whether the real estate investment client is a master real estate fund…or a sole individual looking to invest alone or in a group…knowing the three ways to determine property value remains a basic skill.
Without going into too much detail, we will identify the three methods of valuing a real estate investment as the…
(1) sales comparison approach (also called comparable market analysis), (2) income approach and (3) cost approach (also called replacement cost approach).
One should not rely solely on the sales comparison approach when buying property.
Because assessing property value by collecting and analyzing the recently closed sales of comparable properties is generally used to determine the value of existing residential property…
In other words, this does not necessarily tell you what the cash flow potential of the real estate investment is.
The income approach, on the other hand, is designed to assess a real estate investment by capitalizing the income of the property. This method is used to determine the value of commercial property; or any property purchased with the intention for maximizing cash flow.
Using the income approach to maximize a real estate investment is an art just as much a science.
What do we mean by that?
In a nutshell, because the value of this type of property is determined by cash flow, one can imagine that the value of the property is directly related to how well the management can keep the property leased-up (rented); while controlling the expenses.
Lastly, the replacement cost approach computes the replacement cost of improvements (predominantly the “hard costs”) used to construct the property. And then adds the value of the land to arrive at the fair cash value of the total asset.
The more one knows about building, construction and real estate development, the easier it will be to analyze a real estate investment using the cost approach. Basically, you need to know what things cost (materials, land and etc) to make proper use of the replacement cost approach.
In reality, I personally use all three methods when evaluating any real estate investment or buying property opportunity. In other words, the more you know about each rudiment in real estate, the easier it becomes to cross reference each valuation method against the other.
If you’re looking at a real estate investment opportunity (or selling property for that matter)…and cannot assess the property value using all three approaches within a couple-of-minutes…then learn how to from your top real estate consultant.
Otherwise, it could be a disaster.