1. How We Determine the Value of Our Real Estate
Here's a quick primer on determining the value or both Residential and Commercial Real Estate. Terms used: Comps, Comparables, GRM, Cap Rate, Cap Rate Compression.
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First, lets define a few turns.
-Residential, 1-4 units (IRS considers 1-5 units residential)
Commercial is greater than 4 units
- Residential Real Estate is valued very similar to commodities or stocks. You can only sell for what the next person is willing to buy it at. If you have more buyers in the market than sellers, then the price will go up as buyers compete with each other. This is called a sellers market. If there are more sellers than buyers then the sellers will have to lower their price to find a buyer. We call this a buyers market.
-comps Your agent or broker can pull data from the local MLS to find out what similar homes in the area have recently sold for. From this information, both parties can figure out what to sell or buy a property at.
-You may see something called GRM, or Gross Rent Multiplier used with multifamily properties but not single. This is the ratio of the property’s gross annual rent and property price. The GRM will tell you the number of years the property will take to pay for itself just by considering gross rent. If you’re considering investing in a fourplex in an area with lots of multifamily then I’d want to know how my projected rents and property price compare to other similar properties since we’ll be competing for the same tenants. The GRM will differ from market to market. A rural midwestern market may have a low GRM like 5 or 7 and a coastal market like san diego, where we are, will have GRMs in the high teens.
Commercial real estate is valued just like a business. Take your Revenue, subtract your expenses minus the mortgage payment, and you get your Net Operating Income. Once we have our NOI, we apply our capitalization rate to get the value of our property. As you can see, anything that affects the revenue or expenses of our property directly affects the property's value. Owners who manage their properties poorly get punished when it comes time to sell. This also creates an opportunity for an investor to buy a property, increase rents through better management or repairs, get the expenses under control and stabilized, then realize a much greater value in the property.
-CAP rate is determined by dividing the NOI of a property by the purchase price. But what determines the cap rate? Generally speaking, the class of property and the overall condition of the market. Manhattan real estate might be trading at an amazingly high 2 percent cap rate, but our rural midwestern market might be at 10 or higher. As more buyers flood into a market, you’ll see what is called “cap rate compression”. Where cap rates go higher as buyers compete for the same property. This is happening in hot multifamily markets right now.
Let’s look at an example of how different cap rates can affect the same theoretical property. The property price doesn’t matter. Let’s take a look at a 25,000 increase in NOI for a theoretical property valued at both a 4 cap and 10 cap.
25,000 increase in NOI increases price of a 10 cap rate property by 250,000
25,000 increase in NOI increases price of a 4 cap rate property by 625,000