Property Futures

Real Estate News, Reviews and Investment

Valuation of Investment Real Estate

Article: assessing the market value, risk and income of real estate

Is it the right investment?  If so, both market value and inherent worth will increase over time, offering an investor financial gain.  The first step to assessing the value of any real-estate investment is to understand the valuation process.

Unlike other property that you may buy for personal reasons, such as a home where you plan to live, a real estate investment should be viewed purely pragmatically and valued based on the likely or actual returns on investment.

investment property

How much should I pay for this property?

This is the big question most real-estate valuation surveyors are trying to answer, and he or she will usually do so in one of two ways:

  • Assessing the market value
  • Assessing the likely return on investment (ROI)

When buying a family home, you are probably only going to consider the market value, but when buying an investment property, the market value is only important in so far as it affects the (ROI).

What is a good rate of return?

In general with risk vs. return, the less risk involved in a venture, the lower the rate of return, and high-risk/low-return ventures are usually foolish investments.

A good rule of thumb

  • The returns on a real-estate investment should be higher than on your savings account.

Real-estate investment is likely to be riskier than keeping your money in a standard savings account but that also means the rate of returns on a good real estate investment should be higher.

Assessing the likely return on a real-estate investment 

The two main ways to profit from real estate are:

  • Renting it out
  • Selling it

It’s fairly clear how selling a property for a higher sum than you paid will generate a profit, but the calculations for rental properties are more complex.

Rent per month x 12

If you already have an idea of the rental value of a property, it’s tempting to simply multiply this figure to get the rental returns in one year, and call it done.

However, this will only give you the maximum potential return. In reality, even if you get the rent you ask for, returns will be lower due to:

  • Empty days or months
  • It takes some time to find good tenants
    • Holiday investment properties come with a ‘high season’ and usually a ‘low season’ as well.
  • Non-payment of rent
    • Even if you recover it through small claims courts, the costs will affect your income
      • Repairs, property taxes and more
  • Operating costs

Net Operating Income (NOI)

The net operating income for a business or rental property is: 

(total income) – (operating costs) = (NOI or NOL)

If income is lower than the costs, this is called a net operating loss (NOL)

Operating costs include:

  • Property management services
  • Insurance
  • Maintenance and repairs
  • Property taxes
  • Any utilities paid by the owner or property manager

Operating costs do not include:

  • Income or capital gains tax
  • Loan interest

Unless you have a lot of real estate experience yourself, you will usually need to consult a real-estate professional, such as an accountant or financialadvisor, to get an accurate NOI.

  • Even if calculated by a professional, however, an NOI is still a prediction and not a guarantee of income.

Compare operating costs to loan repayments

Once you’ve calculated the NOI of a property, it is easy to compare it to any loan repayment:

Is the NOI higher than the interest-only mortgage repayments? If not, then the investment has a negative rate of return – you will lose money. Here’s the calculation:

(typical NOI) – (loan interest) = (profits)

Most mortgages pay off both the interest and a part of the capital every month or year. If the NOI is less than the mortgage repayment rate, you will either have to switch to an interest-only mortgage or make up the difference each month. In this latter case, you will be increasing your investment funding each month and this may not be sustainable in the long term.

Return on investment (ROI)

Profits tend to be taxed, so to calculate the return on investment, you should take this into account.

 (profits) – (tax) = (ROI)

In the calculations we’ve been working through, this would be a fixed sum per year. To make comparisons simple, this usually expressed as a rate of return.

Rate of return on an investment

The rate of return is a comparison between the return on an investment and the initial investment. For example, while $100 is a nice sum of money in many currencies, it’s an excellent return if the risk is also $100, but a poor return if you’re risking $100,000.

Rate of return is usually expressed as a percentage, most commonly per year.

(return on investment) / (initial investment) x 100 = (rate of returns %)

As a simple example, if you put $100 (any currency) into a bank account and the bank pays you $105 at the end of one year, then you had a 5% per year rate of return on your investment.

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