How do you evaluate investment property?

March 19, 2013

I will assume the appraised “house” is where they live. If there is different income producing properties, they must be evaluated individually. The answer to your question is that a true appraisal, one that was prepared by a state licensed real estate appraiser will always include an analysis for the cost new approach, the income approach and the market value approach…

Apartment building

Apartment building

Reader Question: My parents have rental properties and are thinking of selling them off to fund retirement. How would you go about evaluating investment property? We know what the house appraised for, but do you somehow figure in the income the property makes? I guess what I am asking is ” Is the property worth more than the appraisal when sold as an investment property?

Monty’s Answer: Hello Brady, thanks for the question. I will assume the appraised “house” is where they live. If there is different income producing properties, they must be evaluated individually. The answer to your question is that a true appraisal, one that was prepared by a state licensed real estate appraiser will always include an analysis for the cost new approach, the income approach and the market value approach. The necessary information is gathered and researched for each of the approaches, as each approach requires different information and methods to determine the value. This fact is apparent in their labels.

The long view

The appraiser then determines if each approach delivers equal value to the appraisal process, or if they should be weighted based on contributing factors that would make any of the approaches less, or more beneficial. For example, if the property were in a community where there is no additional land available to build a building similar to the one being evaluated, the appraiser may choose to eliminate or significantly reduce the value of using the cost new approach. This would rarely be true with the income approach because the use of the property is to generate income. If the property is vacant and producing no income, the appraiser will determine what it will cost to produce rent. They will also project what a reasonable amount of rent could be generated, and they will factor in time to stabilize the income stream. There are many factors the appraiser considers in determining how to weigh the approaches.

The balancing act

The next step is to the meld the values from each approach into a final indicated value. This valuation then becomes the “appraisers opinion of value”, the justification for each approach and the data behind them. The term “opinion” is an extremely significant word in this context because if you hired 10 appraisers, they each have an opinion, and they would be different. It is possible that a change in use of a particular property can affect the value positively or negatively. Another factor that makes their task difficult is that a property does not have a “price”, it has a “range of value”. It is most difficult to sell above that range, and becomes easier to sell as the price drops down the range. Personal circumstances often produce outcomes below the bottom end of the range.

What happened?

If you received an appraisal without an income approach section, nor an explanation as to the reasoning behind that decision, you do not have a valid appraisal. Here is a link to an article that explains how to value a home that adds more general information. I suspect you have a broker price opinion (BPO) and not an appraisal. Learn more about the process to understand how to read these documents. Here is a link to an article about challenging an appraisal that may be helpful.

Take a last look

You did not ask this question, but I feel compelled to broach the subject. There are many people today holding off on selling income producing real estate because to sell it means potential or certain reductions in income. Have your parents compared the after tax income of an outright sale against the net income after property management expenses and no sale? It may benefit them to seek an opinion from a competent CPA/estate planning attorney only doing that kind of work. Today, there seem to be no risk free investments; every investor has a unique situation and goals; and the real estate market and tax laws keep changing.

As an example, I know retirees receiving about $7,500 net annually from real estate investments. They chose not to sell because their income would drop to about $2,500. Their property is professionally managed.

I hope this information is helpful, Brady. Ask me other questions.

Respectfully,

Monty