The current market in the greater Richmond area is making the ownership of local rental properties a very intriguing and lucrative prospect. When trying to decide whether or not you should acquire a specific rental property, it is vital to check that proper valuation on the property has been calculated to ensure that it is a potentially profitable investment. In our last blog, we went over a few methods that can be used to determine valuation for a property. We discussed the following approaches:
- The income approach
- The sales comparison approach
- Gross rent multiplier
Please feel free to visit our last blog to get the details on these approaches. In this blog, we are going to go over additional methods that can be used to determine the proper valuation of assets.
The Capital Asset Pricing Model
This model is more comprehensive and all-inclusive than the approaches we discussed in the last blog post. This approach keys on the estimation of the opportunity cost and the inherent risk as they pertain to the purchase of a specific property. CAPM establishes multiple bases for comparison, such as the rate of return on US Treasury Bonds, or the rate of return on Real Estate Investment Trusts (REITs) in the area. These kinds of investment vehicles have essentially zero risks associated with their acquisition. After the basis has been determined for these relatively worry-free instruments, the Capital Asset Pricing Model estimates the potential return on investment (ROI) for the asset. When the estimated return on investment is less than the return associated with one of the risk-free investment options, it wouldn’t necessarily be a smart decision to purchase an asset that contains built-in risk but has a lower expected return.
The inherent risks of owning property do change somewhat from property to property. Location is one important variable that warrants attention. If the property happens to exist in a crime-ridden area, the amount of rent an investor can expect to receive from the property will likely be significantly lower than the amount that would be collectible in a safer area. Additional monetary investment may be necessary for safety precautions in these more dangerous locations. Extra locks, fences, and even potentially bars on windows may be a wise purchase in order to protect your investment.
The age of the property you are considering is also an important factor to take into account. The older a building is, the more maintenance you can expect it to require to keep it in serviceable condition. After considering these factors, the CAPM helps you decide what specific rate of return should be collectible for putting hard-earned money “at-risk” with this investment. The return should be higher than the rate yielded by the risk-free options available in the market. Otherwise, the property is probably just not the best investment option you can find.
The Cost Approach
The cost approach is formulated on the concept that a piece of property is only worth what it can be reasonably and legally used for. This method figures out the value by adding the depreciated value of any improvements made to the property with the value of the raw land. This method is almost always used when assigning a valuation to vacant lots or unimproved pieces of land.
Zoning is also a key factor to take into account when it comes to the cost approach. If the parcel of land under consideration is not presently zoned for the purpose that the investor prefers to use the land for, there will be a significant cost associated with getting the property re-zoned. If a specific parcel of land is zoned for single-family homes, the zoning would need to be repurposed for high-density housing in order to build a condominium complex on that piece of land.
In the last couple of blog posts, we have discussed ways to perform valuations on properties. The focus has been primarily on the evaluation of properties for investment purposes, but the core principles also apply to the purchase of property for personal use. Successful investors will use a combination of the approaches if not all of the methods that we have discussed before making a decision about a specific property. Once these methods have been applied you can determine how good of a prospect it is. If the investment is found to be potentially profitable, the next logical step would be to begin the process of securing the best financing for the purchase. We will go into the financing process in an upcoming blog.