Real Estate Valuation. The very first thing we do when a potential deal comes to Elkhorn Group is run an independent valuation. Some people call it “underwriting the deal”. There are three standard approaches to valuing a piece of investment real estate: comparable sales approach, replacement cost approach, and income approach.

Comparable Sales. This is the easiest way to see property value. You search for recent sales of very similar properties and see what they sold for. Search Redfin, Zillow, Trulia, and LoopNet for recent sales in your target area. Look for properties that as are close to your target property as possible. Mark down the prices of recently closed transactions and the purchase price per sq. ft, per acre, per room, and so on. Multiply that number by your target property’s sq. ft., acreage, number of rooms and voila, your first valuation.

Replacement Cost. This is another easy way to value property. find out the cost per sq ft to build in your area (call a local contractor) and the price per acre to purchase raw land (use the comparable sales method above). Multiply your target property’s square footage by the price to build and add the land value. That is the replacement value for your property. Your insurance company uses this method to determine your home value so you can use them to double check your answer. Now you have two ideas of what the property should be worth.

Income approach. If you’re purchasing cash-flowing real estate, most people use the income approach to value the asset. This is by far the best method and the most complicated. Stay with me here.

CAP RATE - Each asset class (apartments, industrial land, single family homes, mobile home parks, self-storage) has a Cap Rate. The Cap rate is the percentage of the purchase price that the investor would like returned to them each year. This return is in form of Net Operating Income. Cap Rates differ across asset classes based on a number of factors, primarily risk and intensity of management. The higher the risk, the greater the return people are going to want for their money. Hotels are perceived as being more risky than apartment buildings, so investors demand a higher return from a hotel investment and thus, a higher Cap Rate.

Cap Rate (Percent Return) X Purchase Price = Net Operating Income

or, alternatively

Purchase Price = Net Operating Income / Cap Rate

Cap Rate is measured as a percentage, the annual return on investment. Note: The Cap Rate does not take into account your bank loan. Your return on investment will change depending on your financing methods. If you purchase a property for $100,000 that has a NOI of $10,000 per year, you would call that a 10% cap rate (also known as a 10 Cap).

Okay, are you ready for the income valuation? Find the standard Cap Rate for your asset class by calling a local broker and asking her what the Cap Rates are in your area for industrial land, motels, or whatever type of asset you are valuing. Now you have one crucial element of the equation.

DETERMINING NOI - You have the Cap Rate. Once you find the NOI you can determine the maximum purchase price that you can pay for the property. NEVER rely on the numbers that the seller gives you for NOI. They will pad their income and reduce their expenses to make the property look better.

The best way to find NOI is to start with Gross Income. What is the property making each month in revenue? You should be able to find this number. Make sure that this number makes sense. Make sure that you end up with an annual number, and not the monthly number or year to date number.

Now find the standard expense ratio for the asset class. The expense ratio is a percentage of Gross Income that you can reasonably expect to pay in insurance, management, utilities, taxes, accounting, advertising, and so on. This number changes for each asset class but should be somewhere between 30-60% (I know that’s a big range). We usually use a conservative 50% when looking at mobile home parks.

Gross Income - (Gross Income X Expense Ratio) = Net Operating Income

Or, more simply

Gross Income X (1 - Expense Ratio) = Net Operating Income

Take the Gross Income and multiply it by the Expense Ratio. This number represents your estimated annual expenses. Subtract the estimated expenses from the Gross Income to arrive at your Net Operating Income. Divide the NOI by your Cap Rate and there is the valuation! That’s how you find the maximum purchase price you should pay using the income approach.

These are very simple formulas yet it is hard for many people to grasp the Cap Rate. Assuming a stable NOI, the higher the Cap Rate, the lower the purchase price. The higher the Cap Rate, the higher the perceived risk. Capiche?!

Parting Thoughts: Real estate agents and Local Knowledge. The easiest way to make money in real estate is to purchase a property for less than the market value. That’s what we try to do in every single deal.

Call a few real estate agents and tell them about your deal and ask their opinion of the price and the area. Feel free to give them the address if you feel good about their character. You have it under contract (right? if the deal seems good, get it under contract), so you should be safe from people trying to steal your deal. Talk to the corner store owner, neighbors, anyone out on the street. People know a lot about their neighbors :).

On a separate but related note, keep in mind that values of fixed assets should be related to incomes in that area. One of my mentors, Ned Davis, has a market research company and says the following:

It is my view that the proper way to value assets is to relate them to income. Income is the anchor that truly determines the limits for valuation. The average family can afford a home some four times the amount of their income. In 2005-2006 new homes were selling for well over five times median income, and that simply represented the rubber band of valuation as far as it could be stretched. - Ned Davis Research

Thanks for reading. Will

For every purchase there is a graph of all possible sale prices. On that scale is a range in which the buyer will buy and a range in which the seller will sell. Hopefully, there is a place where those two ranges overlap! That’s where the deal can happen.

As a buyer, you don’t NEED to know the range in which the seller will sell. At first, it’s better if you don’t know the seller’s range because you want to be able to evaluate where your range is independent of the seller’s asking price. Don’t let the asking price affect your own better judgement, especially if there is emotion involved!

What we want to find out is the range in which you, the buyer, will buy? Let’s figure that out.

In order to uncover your range, we want to value the purchase. Don’t look at the price tag! (If you’re looking at real estate and want help figuring out the value, click here). Instead of looking at what the seller wants, think about what the item is worth to YOU? There is likely some emotion involved here, and timing. Perhaps you really need a pair of jeans RIGHT NOW for the party tonight and you want your butt to look good. Okay then, what is the most you would pay for these jeans and still feel happy about the sale? Figure that out, and you have your maximum price in the range. Note that number.

Okay so you have a maximum price, how do you now figure out what to offer the seller? There are two ways.

You can now look at the price tag and pay face value. If it’s at or below your maximum price and you don’t feel like negotiating, you can offer the asking price. I almost never do that, but you still can if you feel like it.
Look at the price tag and negotiate the price. What you’re trying to do here is find out the seller’s range. It helps to find something wrong with the item. If you bring up anything that’s wrong with the item, this let’s the seller lower the price without losing face. They know they priced the jeans to high, but if you ask for a discount without giving a reason, there is less chance they will give it to you. Ask, be nice, and get on their team. Both of you want the sale. Find the happy place (you can read about finding the happy place here).

They still might give you a discount for just asking, “can I get a discount?”. This is one of the easiest and laziest negotiation tools, but it works because most people CAN give you a discount. At Home Depot, they always give me a discount just for asking. It’s madening because I think they should give the discount to everyone. But they don’t.

The jeans don’t fit perfectly but I need a pair right now, can I get 50% off? These jeans are a bit discolored, aren’t they? Do you think you could sell them to me for half price? You can say almost anything and the jeans will get discounted. Shoot for the moon. Ask for 50% off. After asking for 50% off, 15% off won’t seem like a huge discount to the seller. NOTE: 15% off should be BELOW your maximum price. If you’re above your max price after 50% off, you still shouldn’t buy it.

Okay, that’s all for now. Please negotiate for things that are expensive. You can almost always get the price down and still be a good customer. Stick up for yourself and your hard earned money!