The current real estate market conditions in the greater Houston area are making the ownership of local rental properties a very intriguing prospect. When trying to decide whether or not you should acquire a specific asset, it is vital to ensure that an accurate valuation on the property has been performed to decide if it is a potentially profitable investment opportunity. In our last blog, we detailed some methods that can be used to determine the proper valuation for a property. We discussed the following approaches:
- The income approach
- The sales comparison approach
- Gross rent multiplier
Please feel free to visit our last blog to get additional details on these approaches. In this blog, we are going to dive into additional methods that can be used to evaluate potential purchases.
The Capital Asset Pricing Model
This approach is more comprehensive and all-inclusive than the ones discussed in the last blog post. This method gives primary focus to the estimation of the opportunity cost and the inherent risk as they pertain to a specific property. CAPM establishes multiple bases for comparison’s sake, such as the rate of return on US Treasury Bonds, or the rate of return on Real Estate Investment Trusts (REITs) in the area. These investment vehicles have essentially zero risks associated with their purchase. After the basis has been calculated for these essentially worry-free instruments, the Capital Asset Pricing Model estimates the potential return on investment (ROI) for the property. When the estimated ROI is less than the return associated with one of the risk-free investments, it wouldn’t necessarily be a smart decision to make the purchase of an asset that contains built-in risk but has a lower expected return.
The inherent risks of owning property vary from property to property. Location is an important variable that warrants a lot of attention. If the property happens to reside in a crime-ridden area, the amount of rent an investor can expect to receive from the property will most likely be a great deal lower than the amount that would be collectible in a safer location. Additional investment dollars may need to be spent on safety precautions in these more perilous locations. Extra locks, fences, and even potentially bars on windows may be a prudent purchase in order to protect your investment.
The age of the property you are contemplating is also a big factor to take into account. The older a building is, the more maintenance you can expect to need to put into it in order to keep it in serviceable condition. After considering these factors, the CAPM helps you decide what specific rate of return an investor deserves to get for putting their hard-earned money “at-risk” with this investment. The return should always be higher than the rate yielded by the risk-free options that are available. Otherwise, the property is probably not the best investment option.
The Cost Approach
The cost approach is based on the idea that a piece of property is only worth what it can be reasonably and legally used for. This method computes the valuation by adding the depreciated value of any improvements made to the property with the value of the raw land. This method is commonplace when assigning a valuation to vacant lots or unimproved pieces of land.
Zoning is important to take into account when it comes to this method. If the parcel of land under consideration is not presently zoned for the purpose that the investor intends to use the land for, there will be a significant cost associated with getting the zoning changed. If a specific parcel of land is zoned for single-family homes, the zoning would need to be changed to high-density housing in order to build a condominium complex on that land.
We have discussed various ways to perform valuations on properties. The focus has been primarily on the evaluation of properties for investment purposes, but the core principles also apply to the acquisition of property for personal use. Most investors will use a combination of the approaches if not all of the methods that we have discussed to help them make a decision about a specific property. Once these methods have been applied, you can determine how good the property actually is from a financial standpoint. If the investment is found to be potentially lucrative financially speaking, the next logical step would be to begin the process of securing the best financing. We will go into the financing process in an upcoming blog.