Income Property Valuation

Make Sure You Look "Behind" The Numbers On The Page

Income property valuation is often times one of those skills where ignorance is bliss, especially for the "uninitiated" real estate investor. In order to get the "real" numbers required to properly value an income property, you have to dig much deeper than the pro forma statement that the listing agent or owner provides.

If you know that the numbers you are working with in order to value an investment property are accurate, (ie. the cap rate and NOI), the subsequent income property valuation calculation is straightforward.

Value Of An Income Property = Net Operating Income (NOI) / Capitalization Rate

It's arriving at those numbers that takes some know-how, investigative work, and the ability to resist the urge to "make the numbers work". And this is where many first time real estate investors drop the ball. Even an appraisal will not tell you everything you need to know about the numbers so you must know what to look for.

The biggest group of expenditures that are overlooked by many investors are capital expenditures. Capital expenditures occur infrequently but can be (they usually are) very expensive. And the time to budget for them and account for them in your income property valuation calculations is, you guessed it, BEFORE you purchase the investment property.

Let me give you a couple of examples of large capital expenditures I have had.

One of the first commercial real estate properties I purchased was a four-story apartment building with commercial space at street level. An elevator serviced the residential floors, which at the time of purchase was about 16 years old. As a "new" real estate investor I have to admit that I did not investigate the life span of the elevator and hence did not budget for a major capital expenditure in the short term. Well... five years later I was hit with a $40,000 plus bill to replace the elevator. Ouch!

Another example of how capital expenditures can affect income property valuation and cash flows involves an apartment building I purchased about 8 years ago that has wood siding. In the back of my mind I knew that eventually I would have to have the siding re-stained, but again, you tend to put these capital expenditures into the "I'll deal with that down the road" category and focus on just the ongoing expenses. As it turns out, I am just now having the building stained at a cost of over $30,000, which I had budgeted for over the years.

Note: If you are searching for a more thorough resource on commercial property investment/apartment building investment, I recommend this e-course called the "Commercial Real Estate Cash Flow Funding System". It's written by a 31 year veteran of the business and will give you a solid foundation of all the different aspects of commercial real estate investment.

Earlier I alluded to "making the numbers work". What do I mean by this? Well, when it comes to capital expenditures for example, you might not include a capital reserve fund in your income property valuation and/or cash flow analysis in order to "make the numbers work". This typically occurs due to ignorance or foolishness on the purchaser's behalf. And if you think that this type of thing doesn't happen you would be mistaken. Once you become emotionally attached to a real estate deal all sorts of crazy things can happen.

So, what's the lesson here? Well there are a few.

1. Two buildings can have the same NOI and yet not be valued equally. If the building in the second example was finished with a vinyl siding with a 50 year lifespan for example, I would have avoided the $3-$4000 per year cost (on average) to stain the siding, thus adding value to the property.

2. Make sure that you account for the ongoing capital expenditures when conducting your income property valuation and just as importantly, when conducting your cash flow analysis. If you don't, you will pay to much for the investment property and possibly be faced with financial ruin if you are hit with an enormous capital expense bill that you cannot pay because you failed to budget for it.

A great way to quickly (and accurately size up the value of a commercial property is to use spreadsheet software that will do this for you very quickly. Here is one such program (called the Investment Property Calculator that I recommend. Note that it comes in both a U.S. and Canadian version.

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