Three Approaches to Real Estate Value
Real estate can be valued or appraised using three different methods:
1. The Cost Approach – The cost to replace or reproduce the improvements plus land cost. This method is typically used for valuing new construction.
2. The Sales Comparison Approach – Comparison of other recently sold properties that are comparable in size, quality, and location to the subject property.
3. The Income Approach – An objective estimate of what a prudent investor would pay for the property based upon the net operating income the property produces.
The Income Approach is used most in estimating the value of multi-family real estate investments because they are income-producing assets owned by investors seeking financial returns on their investments.
The Income Approach is driven by the formula:
V = NOI ÷ i
V = Value
NOI = Net Operating Income
i = Capitalization Rate or “Cap Rate” (Return on Investment)
Net Operating Income (NOI) is the net income (before mortgage payments) derived from operating the property.
It is important to note that Annual Debt Service (Principle and Interest) is not an operating expense. It is a debt or financial expense paid from the property’s net operating income. Depending upon an investor’s risk tolerance level, properties can have varying levels of debt – or no debt at all. (Depreciation expense is also not an operating expense, and the same is true of a capital replacement allowance.)
The Capitalization Rate or “Cap Rate” is the percent annual return given a specific investment or property value. It is the net operating income of the property divided by its value. Technically, it is the weighted average cost of capital, both debt and equity, invested in an income producing asset. (However, market expected Cap Rates affect values in competitive markets.)
Knowing any two of the three components of the formula V = NOI ÷ i will allow you to solve for the third. Following are variations of the formula:
NOI = Value x i
i = NOI ÷ Value
V = NOI ÷ i
Source: A Real Estate Investor’s Guide To Valuing Multi-Family Real Estate Using Cap Rates By: Dennis J. Noneman, CCIM