When it comes to real-estate investing, there’s one thing that matters regardless of which type of property you’re investing in.
Why does it matter?
Before I explain, there is one thing I need to clarify just so we are all on the same page: The value of a property only matters when you are buying it, selling it, or refinancing it.
Most of you probably know this already, but considering what I saw during the last real-estate crash, I feel like we could all use a hefty reminder. In the aftermath of the crash, I saw too many people panic when their house went “underwater.” They immediately resorted to selling their property because of it’s new super-low value. Uhh, hello…you don’t have to take a loss on a property that you don’t sell!
Now, since we are talking about real-estate investing—and buying and selling is a critical part of this industry—let’s talk about the role property value plays in all of it.
The Key Importance of Property Value
Here it is—when investing in real estate, property value is where you make the majority of your money.
This is true in the following ways:
- If you get a killer deal (purchasing a property for less than its value) you may stand to make a lot of money in the form of equity. On the other hand, if you overpay for a property, negative equity may be the first of several possible streams of income loss.
- If you sell a property for more than you paid for it (and put into it), you profit. If you can’t sell a property for as much as you put into it, you lose money.
- If the value of a property goes drastically up or down, very likely other income streams will be affected in the same way—exit strategy potential, cash flow, tenant quality, vacancy rates—all of these things affect your bottom line.
For example, if you’re flipping a house, it’s very obvious why property values matter—you need to buy below market value and then sell at, or above, the new market value. If at any time the value drops below what you expected it to be, you could face a loss.
If you buy a rental property solely for the cash flow, the property’s ability to sustain steady, positive income may decrease thanks to the same market conditions that cause a property’s value to decrease: decline in population, loss of jobs or industry, extreme vacancy, low tenant quality, and so on.
Real-estate investing strategies allow investors to further maximize profits if they are smart about working with property values.
For example, forcing appreciation is a popular and strategic way to increase profits. In some cases, it may be the only way to make a profit. Forcing appreciation is done by buying a property at a certain price and then improving it, causing its value to skyrocket beyond the initial purchase price (plus however much money went in to improving it). Let’s say you buy a property for $50,000 (and it’s worth that amount) and you put in $25,000 worth of improvements: Suddenly the property is worth $100,000, rather than the $75,000 you spent on it. That’s forcing appreciation via improvements.
I’m going to talk more about forcing appreciation, but let’s first bring this back around to how residential and commercial properties are valued.
How Residential and Commercial Property Values are Determined
It’s important to know how the value of a property is determined. As an investor, you’ll need to understand how to control your property’s value as best you can. When I say control the value, I don’t mean that you will always be able to fix a value depreciation. However, when you know how value is determined, you can make informed decisions early on that will help you achieve the highest possible value for your property.
Oftentimes, one of the first things a newer investor wonders is whether to invest in a residential property or a commercial property. There are quite a few factors that should go into deciding which type of property to invest in, but one of the first things to know is how value is determined.
As a reminder:
- A residential property holds one to four units in which people live. Residential properties consist of single-family homes, duplexes, triplexes, and fourplexes.
- A commercial property is any building with five units or more. It can house people or businesses. Commercial properties include office buildings, restaurants, self-storage facilities, warehouses, and apartment buildings (remember, anything with more than four units is considered a commercial property).
Now, how are these property types valued?
- The value of a residential property is dependent on the market—the real-estate market as a whole and/or the market in the area the property is located in. The condition of the property plays a role in the equation as well, but for the most part, the market determines the value of a residential property.
- The value of a commercial property is dependent upon the income it brings in. A commercial property’s value will be determined in relation to how much money it produces. More on this shortly.
Pricing Residential Properties
Residential property values are often easier for most people to understand because residential markets are more familiar. Residential values will first be determined by the market itself, and then (secondarily) by the condition of that property within the market spectrum. Even a fully rehabbed, beautiful house in immaculate condition can only be priced as high as the market will allow—if seven similar houses nearby (in the exact same condition) are for sale at a certain price, you can’t magically sell yours for a significantly higher price than those seven properties. On the other hand, if you own a complete dumper of a house in an area that everyone wants to live in, you might be able to sell it quite high. Or—like we saw during our more-recent real-estate crash— when housing prices tank across the board, it doesn’t matter where a property is located and in what condition: it will lose value.
Pricing Commercial Properties
Commercial properties are a little more mysterious to many of us. To explain valuing commercial properties, I’m going to use two different examples that will lead back to the same idea: a fast-food restaurant and a self-storage facility.
If you were to invest in a fast-food restaurant as a real-estate investor (not opening up a fast-food franchise), you would buy the building that the restaurant is housed in. That fast-food restaurant would then pay you to rent the space. If you were to invest in a self-storage facility, however, you’d basically be buying a business rather than just the structure that houses the business. In this scenario, your tenants are the people renting storage from you. In the case of the fast-food restaurant, a separate business (that you’re not involved with) will be your tenant.
Either way, you receive income from a tenant of some sort, which determines the value of the property.
Understanding Cap Rates
If you decide to sell a commercial property, the list price will be dependent upon the income it pulls in. The market may have some sway in the matter (because the market can directly affect a business’s income), but prices for commercial properties are not directly market dependent like those of residential properties.
If you deal in commercial properties, you’ll need to understand the concept of capitalization rates. I won’t go into too much detail here about cap rates. The cap rate compares a property’s income to the price at which it’s being sold. The equation is, in its most basic form, annual income divided by purchase price. A positive cap rate means the property is bringing in positive income. A negative cap rate means it’s losing cash. Typically, positive cap rates average around 5-8%.
Let’s say the standard cap rate is 7% and your commercial property brings in $80,000 per year. To check your property value, you’d plug those two numbers into the cap-rate equation: $80,000/PRICE=0.07. To get a 7% cap rate, you’d have to price the property at roughly $1,140,000. Follow? If the property’s income increases or decreases from $80,000, the value of the property will have to change in order to maintain a 7% cap rate.
Here’s another way to look at it: If you are evaluating a property listed at $2 million, and it only brings in $80,000 per year, you know you’re looking at a cap rate that’s significantly lower than 7%. Do the math and you’ll see that the cap rate sinks to 4%. While not completely terrible, the cap rate is a bit low and you may want to think twice about buying the property for $2 million.
You can play around with those numbers a little bit. But remember—the value of a residential property depends on the market, and the value of a commercial property depends on the income it produces.
Why does this matter and how can knowing this help you with your investments?
How to Increase Your Property Value
Here’s where the fun begins.
In order to understand how real estate works, it’s important to know how property values are determined. But where this information gets really crucial is when you try to increase the value of an investment property to boost your bottom line.