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Choosing the correct approach to analyzing a real estate investment is as important as choosing the particular property or strategy. Selecting the wrong approach for a particular market or type of property could cause investors to forsake profits. Here is a summary of some different approaches used to assess value and returns.
Sale comparison approach: Compares the subject property to similar properties recently sold and calculates an average price per unit or square foot to determine value.
Gross rent multiplier: A rough estimate of value: take the sale price and divide by monthly potential gross rental income. Generally used by investors who repeatedly buy the same types of property. This method determines the value of a property based solely on potential rental income for the first year.
Limitations: It reflects a one-year snapshot in time. It only works when comparing properties that have similar operating expenses and similar occupancy/vacancy rates.
Direct capitalization (cap rate): Take the net operating income (NOI) and divide by sales price. It is expressed as a percentage of the sales price offered, or a percentage of the price an investor is willing to pay. It accounts for operating expenses, gross rents, non-rental income, vacancy and credit losses.
Limitations: It is a one-year snapshot. It does not account for the present versus the future value of the dollar (known as the time value of money, or TVM). It also does account for owner financing, tax implications, property depreciation and appreciation.
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Author: Patricia Rattray
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