What is Property Value?
Property Value refers to the estimated fair market value (FMV) of a real estate rental property as of the present date.
How to Calculate Property Value?
Broadly put, the estimated market value ascribed to a specific property is determined by the market demand and supply available at the present date.
- Market Demand → The amount of interest from potential investors (and buyers) in the market to purchase or acquire real estate in a specific market.
- Market Supply → The amount of real estate (e.g. properties, land) available for sale in the market.
If the market supply remains constant while market demand increases, the property values in the market should expect to rise, all else being equal.
Therefore, property values constantly fluctuate based on the current balance between market demand and supply, among other factors such as the interest rate environment (i.e. the cost of borrowing).
For a property value estimate to hold weight, the property must have been marketed in a transparent manner, i.e. via non-deceptive marketing, with no hidden matters with influence on the property valuation, such as leaking ceilings or damages.
The two parties involved in the real estate transaction – the buyer and the seller – must have both acted with knowledge of all material information regarding the property, without compulsion, and formally agreed to the sale on their own accord.
Forced Sale Example
If a homeowner is abruptly forced to sell their property to avoid defaulting on a business loan unrelated to the property itself, the “fire sale” nature of the transaction (and expedited process) causes the sale price to not reflect the true fair value of the property.
The buyer in the transaction, in all likelihood, purchased the property at a steep bargain, at the expense of the seller, akin to distressed asset sales in corporate restructuring.
What are the Appraisal Methods to Estimate Property Value?
In practice, there are various appraisal methods to determine the valuation of a property.
The following table outlines the most notable appraisal methods used by practitioners:
|Sales Comparison Approach||
|Income Approach – Direct Capitalization Method||
|Income Approach – Gross Rent Multiplier (GRM)||
|Cost Approach – Replacement Cost Method||
Irrespective of the methods used to estimate the value of a given property, an independent 3rd party appraisal is often recommended for larger-sized real estate projects, alike a fairness opinion in M&A, to ensure the price paid is reasonable.
The certified appraiser is hired to provide an independent property valuation, mitigating the risk of potential mispricing caused by a potential conflict of interest (or any inherent bias).
The appraiser conducts an in-person inspection of the property, including diligence on the surrounding location, market trends, and comparable properties.
Yet, these pricing quotes are not meant to replace a formally recognized appraisal. Instead, the estimated property values are more akin to a “quick comps” analysis and should not be taken at face value, although the algorithms have certainly improved in accuracy in recent years.
“How Accurate is the Zestimate?” (Source: Zillow)
Property Value Formula
Under the income approach, or “capitalization approach” – the focus of our post on conducting a property valuation – the property value formula is as follows.
The cap rate (%) component is determined based on the risk-return profile of the property and other factors, such as comparable properties and current market conditions.
Therefore, while the capitalization rate can be calculated using the following formula, the cap rate input in our property value formula is not a direct calculation, but rather at the discretion of the real estate investor.
But for general reference, the capitalization rate formula is as follows.
The appropriate cap rate to apply in the valuation of a given property is derived from comps analysis, i.e. the investor analyzes the cap rates of comparable properties.
Generally speaking, a higher cap rate implies there is more risk attributable to undertaking a certain real estate project, which coincides with a lower property value because investors in the market require a higher potential yield to compensate for the incremental risk of an investment.
The other income approach – the gross rent multiplier (GRM) method – uses the following formula.
That said, the operating expenses incurred by the property – e.g. property taxes, insurance, repairs or renovations, and utility bills – are neglected.
Like the cap rate, the multiplier applied is based on performing diligence on the property and comps analysis.
External vs. Internal Factors: What is the Difference?
Often, external factors at the macro level are the main catalyst for material changes in property prices in the real estate market, but internal factors can also contribute to pricing fluctuations.
- External Factors → As a real-life example, property prices in Florida and Texas surged post-2020 due to factors such as a more favorable tax structure, political matters (e.g. safety), a relatively lower cost of living, the work-from-home (WFM) trend, and more corporations moving to the Southern region of the U.S. (i.e. more job opportunities). Meanwhile, property prices in areas like San Francisco plummeted in the same time horizon, namely due to the rising crime rate and pent-up frustrations around governance.
- Internal Factors → For instance, a homeowner could decide to implement property improvements like pool installation, repairs, and maintenance, upgrade the property with modern appliances, and implement other value-add initiatives to modernize the house, which are all factors likely to contribute to a higher sale price.
What Causes Property Value to Change?
The factors that influence the property value in a specific real estate market include the following:
- Market Conditions (Supply-Demand) → From a high-level perspective, the main factor that causes a change in real estate property values is market demand. If market demand increases, property value prices tend to rise in tandem, and vice versa if demand in the market declines.
- Inflation → Inflation is the economic state where the general prices of goods and services rise, often due to excess money in circulation. The excess supply in the markets causes the currency to devalue, in which the purchasing power of consumers declines. Given the increase in pricing of general consumer goods amid inflationary periods, a slowdown in the real estate market often follows suit from the widespread fears of a potential recession on the horizon, as well as higher input costs (e.g. construction supplies). Hence, new construction activity has historically experienced significant declines in past recessions while the number of defaults on home loans spiked.
- Interest Rate Environment → The current interest rates in the credit markets and the ease of access to “cheap” debt financing are correlated to the total transaction activity in the real estate market. If the cost of borrowing rises, the demand for home purchases tends to decline since fewer consumers can afford to purchase homes considering the higher cost of borrowing. On the other hand, declining interest rates are favorable to buyers in the real estate market as sentiment improves, and more loans priced at lower rates are offered to finance the purchase of properties such as homes.
- Location and Proximity → The properties located in densely populated cities, most often urban areas such as New York City (NYC), Boston, Los Angeles, and Miami in the U.S., receive higher valuations because of strong market demand. Moreover, the proximity of the property to educational institutions (e.g. high schools, universities), the workplace (e.g. offices), transportation, and other amenities (e.g. food markets, shopping malls) can impact property values in specific areas. For instance, the properties in New York located near the NYC Transit (MTA) fetch higher prices because buyers (and tenants) are more willing to pay a premium for the convenience of living near the public transport system, i.e. to avoid prolonged commutes.
- Safety and Security (Crime Rate) → For many consumers, especially those with families, safety can be a top priority. For that reason, properties located in safer neighborhoods frequently mention their low crime rates in their marketing efforts to drive demand, as well as their measures to ensure safety (e.g. modern emergency response system, security alarms, gated community).
- Design and Layout → Certain properties are often designed to cater to a niche demographic, which can cause prices to rise since the layout is uncommon. The limited supply in a market results in higher property valuation because of the target market’s willingness to pay a premium, i.e. the concept of “scarcity value”.
- Current Condition of Property → The current condition of the property influences property value. For example, a buyer could negotiate a discounted purchase price based on the notion that repairs are required post-sale. Furthermore, outdated features that trail behind comparable properties, such as a worn-out A/C system, can have negative implications on the market demand (and sale price).
- Sales Comparison → The recent sale prices of comparable properties in the same (or adjacent) area often provide useful insights on the appropriate pricing. Therefore, buyers and sellers often reference past transactions in negotiations regarding how much a property is worth.
Property Value Calculator
We’ll now move to a modeling exercise, which you can access by filling out the form below.
1. Commercial Real Estate Property Assumptions (CRE)
Suppose a real estate investment firm is considering a potential acquisition of a commercial office building.
If acquired, the property expects to generate $2 million in potential gross income (PGI), with vacancy and credit losses anticipated to be 5.0% of PGI.
- Potential Gross Income (PGI) = $2 million
- Vacancy and Credit Losses (5.0% of PGI) = 5.0% × $2 million = $100k
Given those figures, we can determine the effective gross income (EGI) by subtracting the expected vacancy and credit losses from the property’s potential gross income (PGI), which is $1.9 million in our scenario.
- Effective Gross Income (EGI) = $2 million – $100k = $1.9 million
2. Net Operating Income (NOI) Calculation Example
The next step is the calculate the property’s net operating income (NOI) by subtracting its effective gross income (EGI) from its operating expenses.
For our hypothetical scenario, we’ll assume the property’s direct operating expenses are 40% of EGI.
- Operating Expenses = 40% × $1.9 million = $760k
The building’s net operating income (NOI) equals the difference between its effective gross income (EGI) and operating expenses, which is approximately $1.14 million here.
- Net Operating Income (NOI) = $1.9 million – $760k = 1.14 million
Note: In more complex real estate financial models – most often for commercial properties – the “Replacement Reserves” is a common line item that further reduces the net operating income (NOI) metric.
3. Property Value Calculation Example (NOI / Cap Rate)
The only remaining assumption necessary to perform a property valuation using the income approach is the capitalization rate (or “cap rate”).
To restate from earlier, the cap rate applied is contingent on the fundamentals of the property and comparable properties in the same or adjacent market.
In our illustrative model, we’ll set up five different scenarios using a step function (+1.0%), in which the only difference is the cap rate.
- Cap Rate (%) – Scenario A = 6.0%
- Cap Rate (%) – Scenario B = 7.0%
- Cap Rate (%) – Scenario C = 8.0%
- Cap Rate (%) – Scenario D = 9.0%
- Cap Rate (%) – Scenario E = 10.0%
The estimated property value under each scenario is calculated by dividing net operating income (NOI) by an appropriate cap rate derived from analysis of comparable properties and market analysis.
4. Property Value Appraisal Example
Once the NOI and cap rate figures are computed for each scenario, we arrive at the following property value estimates.
- Property Value – Scenario A = $1.14 million ÷ 6.0% = $19.0 million
- Property Value – Scenario B = $1.14 million ÷ 7.0% = $16.3 million
- Property Value – Scenario C = $1.14 million ÷ 8.0% = $14.3 million
- Property Value – Scenario D = $1.14 million ÷ 9.0% = $12.7 million
- Property Value – Scenario E = $1.14 million ÷ 10.0% = $11.4 million
In conclusion, our modeling exercise illustrates the fundamental relationship between the cap rate and property value estimates, wherein rising cap rates cause the implied property prices to decline due to the higher risk profiles.