Pricing Real Estate to “Buy Right”

As with any asset, real estate is valued in three ways: asset method, market method and income method.

Market Method: Often referred to as comparable sales method. The question of "fair price" on any piece of real estate is answered by simply determining what similar properties have recently sold for. Real estate brokers can pull comparable sales data for you. The prices may be more art than science because no two pieces of real estate are exactly alike.

Income Method: This method works only for income-generating real estate. The question of "fair price" is answered by determining income generated by the business and then applying a fair rate of return. Following is a table of rates of return on various investments over the past 90 years. Buyers of investment real estate generally require anywhere from 8% to 16% return on investment. If the projected cash flow is estimated to be steady or steadily growing, then a very simple formula can be used to determine value. For example, if the property is projected to generate $100,000 per year in net income, and the buyer thinks a 13% rate of return is fair (given the overall characteristics of the property), then the value is $769,230.77, calculated as follows:

$100,000 = $769,230.77

0.13

Note: The type of income or cash flow used in investment real estate is net operating income (NOI).

Net operating income (NOI) is projected for income-producing property after deducting all operating expenses, including taxes and a factor for expected periodic vacancy and collection losses.

Note: Debt service is paid outside of NOI.

Asset Method: This method is often referred to as the replacement cost method, and is used primarily for owner-occupied real estate. The prospective purchaser asks, "How much would it cost me to build a building similar to this?" He then compares this to a building he is thinking of buying. The rational buyer would purchase an existing building if it could be done at a lower cost than building something new, but would still need to consider issues such as location, condition, maintenance costs, utility costs, remaining useful life, etc.

Which method should you use? Smart buyers use them all. When looking at a piece of property, they run the numbers using all three methods and consider the insight gained from each. They use the resulting information to assess what they think is smart for themselves, and also to negotiate strategically with the seller.