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Determining the Value of Investment Property Held for Income
Value is in the eyes of a owner
Return in the eyes of an investor.
Most investors make the majority of the money they eventually earn on an investment at the time of purchase. Remember "buy low sell high?" As a result, understanding the following information is imperative for any real estate investor. However, what we provide on this page is "elementary my dear Watson". The subject is so important that we have created a very extensive e-course called Valuing Income Property.
Influences on Value
Four factors influence value, either positively or negatively: physical, economic, governmental and social.
- Physical influences include the property location, it's condition, the climate, soil type, environmental factors and flooding.
- Economic influences include local median income, unemployment and vacancy rates, as well as mortgage availability and interest rates.
- Governmental influences include rent controls, taxes, fees, regulation, mandatory inspections, building codes and zoning.
- Social influences include family size, population age, shifts, and changes in housing tastes and preferences.
The climate is a good example of a physical influence on value. In northern areas cottages demand the highest prices for about three months in the summer and a much lower price in the winter. Southern areas are, of course, the reverse. In fact, a landlord in a resort area can usually receive the same rents in a three month season as they get for the same unit over a whole year lease.
Characteristics of Value
Four characteristics must be present if a property is to have value: desirability, utility, scarcity, and transferability.
- Desirability causes a majority of prospective buyers to want to own the property.
- Utility makes a property useful to a majority of prospective buyers. (ie, home-owners as well as investors.)
- Scarcity causes a majority of buyers to want to act faster, since fewer other properties similar to the subject property are available at the same time.
- Transferability is the ability of a majority of buyers to afford the price or terms that allows more buyers the opportunity to purchase.
If a property is missing any of these characteristics, it will suffer a loss of value (depreciation). The four influences on value listed above (physical, economic, governmental and social) are what cause the characteristics of value (desirability, utility, scarcity and transferability) to change.
Types of Depreciation
There are three general types of depreciation which may cause property to suffer a loss in value: physical deterioration; functional obsolescence; and external obsolescence.
- Physical deterioration is a loss of a property's value due to ordinary wear and tear with subsequent deferred maintenance. This physical influence causes a property to be less desirable and less useful when compared to other properties. Examples include old paint, broken windows and leaking roofs.
- Functional obsolescence is a loss of a property's value due to certain inadequacies, such as old wooden storms and screens, small bedrooms and just one bath, or even to over improving compared to other properties in the general area. It may also result from changes in needs, tastes and attitudes which helps contribute to a diminished usefulness.
- External obsolescence is a loss of a property's value due to outside forces beyond the control of a property owner, unlike physical and functional forms of depreciation. There are two types: locational and economic.
a. Locational external obsolescence is a loss of value due to negative physical influences outside the property. Examples could be: abandoned neighborhood shopping centers, excess traffic, landfills, mixed land uses and environmental contamination.
b. Economic external obsolescence is a loss of value due to negative economic forces outside the property. Examples may be: plant closing with subsequent high unemployment, rising interest rates, lack of available financing and loss of population.
A successful investor, like a professional appraiser, should be trained to determine the types of depreciation a property may suffer and the resulting impact on it's market value. We should never assume that all depreciation is contained within the boundaries of a property either. We must be aware of changes in a subject property's surroundings and the condition of the local market.
Price, Cost and Value
New investors sometimes have difficulty differentiating among price, cost and value. They may assume that the price they pay for a property is also its value. They may also erroneously assume that the cost of any improvements made to a property add to its value.
Definitions
- Price is the amount paid for a property. Bank appraisers and real estate brokers use the prices paid for comparable properties as a means of estimating the market value of a subject property.
- Cost is the amount of money that a property owner has invested in a property. For example, a buyer's cost in a property as of the day of closing includes the costs incurred in locating and negotiating the purchase, price, legal fees, and all other closing costs.
- Market Value is an estimate of the price upon which a typical buyer and seller may agree, providing neither is under duress, they are working in their own self-interest, both are reasonably informed about the market, and the property has been exposed to other potential buyers for a reasonable period of time.
Value is not necessarily indicative of the price a current owner has paid for a property, or the amount invested in improvements. It may also have little relevance to the purchase price and terms an investor is able to negotiate. However, estimating a property's value is among the most important tasks faced by investors.
The subject is so important that any serious real estate investor should take our e-course on Valuing Income Property.
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