If you’re seriously considering investing in the DFW area, there’s a good chance you’ve been looking at a lot of properties.
As you narrow in on a specific location in DFW, you may be wondering how you can quickly determine the value of a property. This handy guide will point you in the right direction so you can learn how to value a property.
When Should You Determine the Value of an Investment Property?
The first step in the buying process is to choose a price point. You should choose a price range you’re comfortable with and only look at properties within that range.
Once you find a few properties you’re interested in, it’s time to figure out what they’re really worth. You should know how much the property can potentially make in revenue before you make an offer.
What Do You Risk If You Check the Wrong Sources or Value a Real Estate Property Incorrectly?
The major risk to overvaluing a property is you’ll end up making less than you expect. You’re likely to end up with a property that has negative cash flow.
How Do You Determine the Value of an Investment Property and How Do You Choose the Right One?
There are several ways to determine the value of an investment property. How you value a property depends on what kind of investment you’re interested in.
The easiest way to determine a real estate’s property value is to figure out how much the property could generate.
For example, say the property could potentially generate $2,000 a month. Provided the property is not vacant for the entire year, the property would make $24,000 annually.
Once you’ve assessed this amount, you’ll need to add up your annual costs. To figure out your overall costs, you’ll need to combine the sales price or mortgage plus total expenses and repairs.
Take your total income and subtract your expenses. Once you have this number, divide it by your initial investment. This equals your rate on investment (ROI).
This is a lot easier to explain using real numbers, so we’ll provide a couple of scenarios below. For the sake of simplicity, we’ll use two examples. One example includes an all-cash transaction, and the other is a partially financed transaction.
How to Calculate the ROI on a Cash Transaction
In this scenario, let’s say you’re calculating the ROI for a house in Fort Worth, Texas. The initial cost of the home was $200,000. Your closing costs were $1,000, and you had to spend $5,000 in remodeling and repairs costs. (Note: these numbers are examples and shouldn’t be relied upon when making actual purchase decisions).
Your total investment cost is $206,000.
Your total expenses would include your taxes, insurance, and HOA fees. Let’s estimate this to be around $650 a month.
Let’s assume you’re able to rent out the property for eleven months out of the year for $2,000 a month. You may be able to rent it out for the full twelve months, but conservatively you can expect some vacancy time.
To do the math, multiply your monthly income by 11 to get your annual income minus one month’s vacancy. Multiply expenses by 12 to get an estimate of your annual costs.
$2,000 x 11 = $22,000 = Your annual income
$650 x 12 = $7,800 = Your annual costs
Next, subtract your expenses from your income.
$22,000 – $7800 = $14,200 = Your annual return.
Finally, divide the annual return ($14,200) by the total investment ($206,000).
$14,200 / $206,000 = .068 or 6.8%
Your ROI is 6.8%.
How to Calculate the ROI on a Partially Financed Transaction
For this scenario, let’s assume all the numbers are the same, but instead of paying in cash, you chose to finance part of it.
The initial cost of the home was $200,000 and you chose to put down $50,000 upfront. Closing costs with a mortgage are higher, so we’ll estimate $3,000 in closing costs.
It costs the same $5,000 for repairs.
Your total out of pocket expense is $58,000.
Your expenses are the same + your mortgage. Using a mortgage calculator at 4% interest for a 30-year mortgage, your monthly mortgage payment would be $716.
Total expenses would be around: $1,366 a month or $16,392 annually.
Rental fees set at $2,000 for eleven months would be $22,000 annually.
Subtract your annual income from your annual expenses.
$22,000 – $16,392 = $5,608 = your annual return.
To calculate your ROI, divide your original out-of-pocket expenses by your annual return.
5,608 / 58,000 = .096 or 9.6% =
Your ROI is 9.6%.
It should be noted that these prices are just hypothetical and may not reflect the actual cost to buy or the real rental price value.
The simple equation also does not include the cost of repairs that are likely to come up with any rental property.
Lastly, it may seem strange that a property paid in all cash has a lower ROI. Financing boosts your ROI in the short-term because your initial costs are lower. However, your monthly cash flow is higher when you pay in cash.
Comparing This Valuation Model With Others
The above example is something called an income approach. It’s focused on how much money the house makes. In other words, it shows you what kind of cash flow the house generates. At LEAP, we use this over a sales approach which focuses on comparable sales.
A sales approach is when you buy a real estate property and plan to make money when it appreciates in value. With this approach, you’re buying a property primarily to sell it at a better price in the near or distant future.
The sales approach is a little more of a gamble. If you base your real estate investment on the sale of a property and the economy goes down, you’ll lose money on your investment. Plus, you have to sell the property before you can make a profit.
Some people prefer to buy properties solely to sell them later at a better price. If this is the end goal, they may not mind renting out a house that has negative cash flow.
At LEAP, we prefer to look at houses that generate positive cash flow each month. If you do choose to sell the house in the future, the appreciation value of the home is a bonus.
The Last Word on How to Determine the Value of an Investment Property
Determining the value of a property does not have to be difficult.
First, decide what ROI you would like to make. Next, think about whether you would like to use a sales approach or an income approach.
Once you know your approach, calculate how much potential profit each property can make.
If you’re interested in an income property, remember that your rental needs to be cash flow positive. Your profit should always be higher than your expenses.
LEAP Property Management has years of experience working with properties and can help determine the value of a property.
Once you choose a property, LEAP will help place tenants and maintain your property so you can stay cash flow positive.
Contact us today to learn how we can help make your investment dreams a reality.