It can be confusing trying to understand how to value a particular piece of property. Real estate is an extremely varied asset class with many different niches including Single Family Homes, Multi-family, Office Space, Raw Land, Industrial, and on and on. Each niche has its own valuation calculation but all real estate falls into two basic categories: Residential and Commercial. These categories are separated based on the type of financing offered and are therefore valued differently.
In residential real estate, (typically defined as Single Family Homes and multi-family properties with 2-4 units) comps are used to determine value and loans are extended based on an individual’s ability to repay the loan with income from their job or businesses. Appraisers will look at what similar properties in the area sold for, what condition they are in, and what features they have and compare them against the subject property to determine a value.
In commercial real estate, (defined as anything other than Single Family Homes and multi-family properties with 2-4 units) comps are not the primary factor of valuation. Instead, commercial properties use the NOI, or Net Operating Income. This is a measure of the income a property is able to produce minus regular expenses. Loans are extended based on the income the property can produce and if that income can cover the loan balance. The focus is on the asset’s ability to pay the loan, not the borrower.
Even though commercial real estate is valued primarily through NOI, it’s still important to look at comps. Let’s say you see a 20 unit apartment complex for sale and it’s listed for 1,000,000 dollars, or 50,000 per unit. The NOI of the property lines up with your expectations and it appears to be a good deal. Let’s say you do some further research and find that similar properties in the area sold for 30,000 per door. This doesn’t mean that the subject property is a bad deal, but for me, this would warrant asking the question of why the subject property is valued at such a premium. There may be a perfectly valid explanation. Perhaps the property recently underwent major renovations and all of the other sold properties were badly run down, but it’s important to know the reasoning behind this. Oftentimes, the answer is simply a seller out of touch with the market.
But wait you say, what if a residential multi-family building has a very very high NOI and it looks like it should be valued much higher than the residential comps? Unfortunately this doesn’t matter when calculating the overall value. As a buyer this is a good thing. It can provide a good negotiation point for a buyer. As a seller it is unfortunate. As a buyer i’ve seen many sellers try to price their residential multi-family buildings based on NOI. Even if I wanted to buy an inflated amount, a bank wouldn’t approve a loan for an inflated amount.
It’s important to always make sure you’re valuing a property accurately so you don’t overpay and risk losing money on your investments.