The current market in the greater Anaheim area is making investment properties in the area a more and more lucrative proposition. As an investor considers whether or not to purchase a specific property, it is imperative to be sure that they have calculated the proper valuation on the property to ensure that it’s a good investment. In our last blog, we discussed some methods that can be used in order to assign accurate valuation to a rental property. We discussed the following approaches:
- The income approach
- The sales comparison approach
- Gross rent multiplier
Please feel free to visit our last blog for more details on these three methods. In this blog, we’re going to go over a couple of additional calculations that can be used to ensure the proper valuation of properties.
The Capital Asset Pricing Model
The Capital Asset Pricing Model is more comprehensive and detailed than the methods we discussed in our last blog. This valuation method strives to include opportunity cost and inherent risk as they pertain to the potential purchase of a specific asset. CAPM sets a couple of different bases for comparison, such as the rate of return on US Treasury Bonds, or Real Estate Investment Trusts (REITs) in the local geographic area. These investments have essentially zero risk associated with them. After the basis has been established for these non risky investments individually, the model estimates the potential return on investment (ROI) for the property. If the estimated return on investment is less than the rate of return for one of the risk-free investment options, it doesn’t make sense to purchase an asset with an inherent risk that has a lower expected return.
The inherent risks of owning real property typically vary widely from asset to asset. Location is one very important factor to consider. For example, if the property is located in a crime-ridden area, the amount of rent you can expect to charge will most likely be significantly lower than the amount collectible in a safer neighborhood. You may also need to make expenditures for additional safety precautions in more dangerous areas. Extra locks, fences, and even potentially bars on windows may be necessary to protect the asset.
The age of the property is also an important factor because the older a building is, the more maintenance you can realistically expect it to need. After taking all of these factors into consideration, the CAPM helps you determine what rate of return you realistically deserve to get for putting your money “at risk”. Once again, that ROI should be higher than the rate yielded by risk-free options in the market. Otherwise, it is not a good investment option.
The Cost Approach
This approach is predicated on the notion that a piece of property is worth what it can be reasonably and legally used for. You figure out this number by adding the depreciated value of any improvements on the property to the value of the land itself. This method is of significant importance when assigning value to unimproved lots or vacant land.
Zoning also factors heavily into the cost approach. If a parcel of land is not currently zoned properly for the use the investor intends, there will be a significant cost associated with getting the property re-zoned. For example, if a property is zoned for single-family homes, you would need to get the zoning changed to high-density housing in order to build a condominium complex on the land.
In the last couple of blog posts, we have covered five ways to calculate valuations on specific investment properties. Successful investors will use a combination of at least some if not all of the methods we have discussed before making an investment decision. Once these methods have been applied to analyze a specific property and it’s deemed a good investment, the next step is to begin the process of securing the best financing for the purchase. We will go into this process in more depth in an upcoming blog.