Investing in real estate can be a great way to generate income and build wealth. But before taking the plunge, it's important to understand how to accurately value a potential investment. There are several methods used to determine the value of a property, including the Sales Comparison Approach (SCA), Capital Asset Valuation Model (CAPM), Revenue Approach, Gross Rent Multiplier (GRM) and Cost Approach. The Sales Comparison Approach (SCA) is one of the most recognizable ways to value residential real estate.
It is the method most used by appraisers and real estate agents when evaluating properties. This approach is simply a comparison of similar homes that have been sold or rented locally for a given period of time. Most investors will want to watch an SCA over a significant period of time to spot any potential emerging trends. Keep in mind that SCA is somewhat generic, meaning every home has a uniqueness that is not always quantifiable.
Buyers and sellers have unique tastes and differences, so it doesn't work if you're going to value the property you're interested in with another property that has different features. The Capital Asset Valuation Model (CAPM) is a more comprehensive valuation tool. The CAPM presents the concepts of risk and opportunity cost applicable to real estate investment. This model analyzes the potential return on investment (ROI) derived from rental income and compares it to other investments that do not present any risk, such as United States Treasury bonds or alternative forms of investment in real estate, such as real estate investment trusts (REITs). Put simply, if the expected return on a guaranteed or risk-free investment exceeds the potential ROI of rental income, it simply doesn't make financial sense to take the risk of a rental property. The Revenue Approach focuses on what produces the potential income of a rental property relative to the initial investment.
It is frequently used for commercial real estate investment because it examines the potential rental income of a property in relation to the initial outlay of cash to purchase the property. This is a very simplified model with few assumptions. Most likely, there will be interest expenses on a mortgage and future rental income may be more or less valuable five years from now than it is today. The Gross Rent Multiplier (GRM) approach values a rental property based on the amount of rent an investor can collect each year. It's a quick and easy way to measure if a property is worth the investment.
This, of course, is before considering any taxes or other expenses, such as insurance and public services associated with the property, so it must be taken with reservations. While it may be similar to the revenue approach, the gross income multiplier approach does not use net operating income as the maximum rate, but rather gross income instead. The Cost Approach to valuing real estate states that property is only worth what it can reasonably be used for what. It is estimated by combining the value of the land and the depreciated value of any improvement. Appraisers at this school often advocate the best and highest use to summarize the cost approach to real estate.
It is often used as a basis for valuing vacant land. For example, if you are an apartment developer looking to buy three acres of land in an arid area to convert them into condominiums, the value of that land will be based on the best use of that land. When determining the value of a potential real estate investment, investors should consider all available methods and weigh their pros and cons carefully. The Sales Comparison Approach (SCA), Capital Asset Valuation Model (CAPM), Revenue Approach, Gross Rent Multiplier (GRM) and Cost Approach are all useful tools for valuing properties but each has its own limitations. Investors should also take into account factors such as location, age of property, crime rate in area and zoning when making their decision.
