How to Correctly Value an Investment Property

[Joe Latson]

Hey BP!

I hope some of you find this post helpful.

How do I correctly value an investment property? Simplistically, a valuation is a measure of how much a specific property (the “subject property”) is worth. Framed differently, at what price is an investor willing to buy the property, and the owner willing to sell?

When you peel back the layers, there are really two types of valuations: a “market valuation” and an “internal valuation,” sometimes called a “personal valuation.”

The market valuation is the broader market’s view on what a property is worth. Each property has only one market valuation. There is a formal process for determining this value, typically completed by a third party such as a licensed appraiser or real estate broker not involved in the transaction. Most lenders rely on a third-party valuation to inform loan amounts.

Internal valuations are more nuanced – they incorporate a wide variety of inputs and vary from investor to investor. While market valuations are largely informed by recent comparable transactions, internal valuations reflect what investors are willing to pay based on a number of factors, especially forecasted investment returns.

The significance of valuations depends on what stage a deal is in its investment lifecycle. Are you looking to buy, or considering selling? All buyer profiles – consumers, individual investors, and institutions – rely on some sort of valuation. It is a best practice to establish an internal view of a property’s value before placing an offer.

Can a property’s valuation and price be different?

In a perfect world, with efficient markets and information-parity, valuation and price would be the same. Economists often base predictions in this so-called “perfect world.” However, real world investors know better. There are times when valuations and the price someone is willing to sell differ – sometimes widely. This is especially true in illiquid markets like real estate.

As a buyer, you aim to take advantage of pricing discrepancies when your valuation is higher than the price, a phenomenon known as arbitrage. Conversely, as a seller, you want to maximize price, regardless of your valuation.

Takeaway

The best investors know that valuations should not be driven by emotions or by their perception of a competitor’s or seller’s value. Maintaining discipline can be hard, but is critical to building a durable track record as a strong investor.

A common mistake is discovering one of your assumptions was wrong or that you missed something, and not adjusting your valuation accordingly. For example, if during diligence you discover the roof needs to be replaced, your valuation should immediately adjust to account for the cost. Even if you decide not to replace it during your hold, you should assume that your buyer will include the cost in their valuation, so it will impact you either way.

If your valuation helps you place a winning offer – that’s fantastic; however, if you get beat on a deal, that’s ok. You should feel confident walking away if the valuation you set does not meet the seller’s expectations, or comes up short vs. a competitor’s offer. Instead, use your time and money to find other properties that better fit your strategy and return targets.

Questions or call outs, let me know!

Thanks, 
Joe