As an Certified Appraiser I can tell you that the most common mistake that many beginning real estate investors make is that they pay too much for property. Fact is overpaying for property is often cited as the number one reason why so many newcomers fail to make it as profitable real estate investors. That’s because most beginning real estate investors are woefully under capitalized, and they don’t have the deep pockets that are needed to subsidize their overpriced real estate investments.

For many neophyte investors, paying too much for their first investment property usually proves to be a very costly and fatal mistake, and marks the beginning of the end of their foray into real estate. That’s why it’s imperative that you learn how to accurately estimate the current market value of potential investment properties! As far as I’m concerned, it’s the single most important aspect of the entire real estate investment business!

A Fast $50,000 Profit for Knowing the Value of a Condemned House

I once bought a real estate option on a filthy, neglected, run-down, but structurally sound house in a neighborhood-in-transition within Los Angeles, California, that had been condemned for building, safety, health and fire code violations. This place looked like something right out of downtown Baghdad, Iraq! It had what code enforcement inspectors commonly refer to as accumulations of every type of debris, garbage and junk known to mankind! The property’s owner lived in Westerville, Ohio, and wanted the steady stream of threatening letters from the Winter Park Code Enforcement Board to stop.

I had done my homework, and knew the property was worth at least $450,000 after it was cleaned up. I ended up paying $2500 for a six month option to purchase the house for $365,000. It cost me $10,000 to have all of the accumulations removed from the property, and the house, driveway and walkways pressure washed. Three weeks later, I sold my real estate option agreement for a $65,000 profit! This never would have happened if I had been clueless about how to estimate property values. Since I had an accurate estimate as to how much the property was worth in its current condition, I was able to negotiate a below market purchase price that was based on the property’s filthy, neglected, run-down non-marketable condition, and not on how much it might have been worth after it had been cleaned up.

No Kelly Blue Book for Real Estate Investors to Look Up Property Values

Sadly, there’s no Kelly Blue Book equivalent for real estate investors to lookup used property prices in, so you’re going to have to learn for yourself how to estimate the current market value of potential investment properties. However, thanks to computers and the Internet, in most real estate markets it’s not that difficult to get a rough estimate of a property’s current market value. This is especially true for real estate investors located in counties where all property ownership, sale and tax assessment records are available online.

The Definition of Market Value

The Appraisal Foundation’s Uniform Standards of Professional Appraisal Practice, defines market value as: “The most probable price a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the sale price isn’t affected by undue stimulus.”

The Difference Between Assessed Value and Appraised Value

The difference between a property’s tax-assessed value and its appraised value is as follows:

1. Tax Assessed Value: Tax-assessed value is the value established by the local taxing authority for a parcel of land and the improvements placed upon the land for property tax purposes. For example, in Florida, owner-occupied single-family houses are generally assessed at around seventy percent of their fair market value by county property appraisers.

2. Appraised Value: Appraised value is the value estimate given to a property by a licensed property appraiser using accepted appraisal methods for the type of property being appraised. For example, the accepted appraisal method to accurately estimate the fair market value for an owner-occupied single-family house is the comparison sales method where a property’s value is based on the recent sale of comparable properties within the same area.

The Three Common Methods Used to Estimate Property Values

The three most common methods used by property appraisers to estimate property values are the:

1. Comparison Sales Method: The comparison sales method bases a property’s value on the recent sale prices of properties that are within the same area and comparable in size, quality, amenities and features.

2. Income Method: The income method is used to estimate the value of an income producing property based on the net income the property produces.

3. Replacement Cost Method: The replacement cost method is based on what it would cost to replace the improvements on property using similar construction materials and construction methods.

The Comparison Sales Method of Estimating a Property’s Value

The comparison sales method of estimating a property’s value is based on the recent sale prices of properties within the same area that are comparable in size, amenities and features. In order to be accurate, sale price adjustments must be made for comparable properties that have been sold at unrealistically low prices or on overly favorable financial terms not readily available to the buying public.

The Income Method of Estimating a Property’s Value

The income method is used to estimate the value of an income producing property based on the net income the property produces. Under the income method value is calculated using a:

1. Capitalization Rate. The capitalization rate, or cap rate, is calculated by dividing a property’s annual net operating income by its purchase price.

2. Gross Rent Multiplier. The gross rent multiplier, or GRM, is calculated by dividing the purchase price by the property’s monthly gross operating income.

Watch Out for Owners Using Fuzzy Math

A word to the wise: when you read a property’s income and expense statement, you should always go under the assumption that the owner is probably practicing fuzzy math by fudging on the numbers, and telling little white lies to back them up. Also, use a monthly income and expense analysis worksheet like the sample copy below, to cross-check everything that’s listed on a property’s income and expense statement in order to reconcile the statement with receipts and tax returns against what’s shown on:

1. Schedule E (Supplemental Income and Loss) of the owner’s latest federal income tax return.

2. The property’s latest annual tax assessment income and expense statement on file at the county property appraiser or assessor’s office.

3. All of the rental agreements for the past year.

4. Water, sewage, solid waste, gas and electric bills for the past year.

5. Repair and capital improvement bills for the past year.

The Replacement Cost Method of Estimating a Property’s Value

The replacement cost method of estimating a property’s value is based on the cost of replacing the improvements on the property minus the cost of the land to estimate a property’s value. Replacement costs are calculated on a per square foot basis by dividing the total number of square feet in the building by the per square foot construction cost. For example, a two thousand square foot convenience store that cost $375,000 to build would have a replacement cost of $187.50 per square foot, $375,000 divided by 2000.

How to Get Free Building Replacement Cost Estimates

You can usually get a free building replacement cost estimate by calling a local independent insurance broker who represents insurers t
hat specialize in providing property and casualty insurance coverage for residential and commercial buildings. When you call a broker, tell them that you want a replacement cost quote. Property replacement costs are calculated by using a replacement cost formula that’s based on the property’s geographical location and its:

1. Street address.

2. Age.

3. Type of construction.

4. Number of stories.

5. Type of roof.

6. Current use.

7. Heating and cooling system.

8. Square footage.

Use the Eight-Step Approach to Estimate a Property’s Current Market Value

Use the following eight-step approach and the current value worksheet on the following page to get a rough estimate of a potential investment property’s current market value:

Step # 1: Log onto your county’s property appraiser or assessor’s Web site to obtain the tax assessed value of the property under consideration.

Step # 2: Search your county’s property tax rolls for recent sales of three to five properties that are comparable in size, amenities and features, and located within two miles of the property under consideration.

Step # 3: Carefully analyze any comparable properties that you find, and make sale price adjustments for differences in amenities, special features and the property’s physical condition.

Step # 4: Verify the income and expenses that are listed on the income and expense statement of the property under consideration.

Step # 5: Analyze the property’s income and expenses for the past twelve months to estimate its net operating income potential.

Step # 6: Calculate the property’s capitalization rate by dividing its potential operating income by the estimated value that you derived from analyzing recent sales of comparable properties in step number three.

Step #7: Estimate the property’s value by multiplying its net operating income by the capitalization rate you came up with for the property.

Step # 8: Calculate the cost of replacing the improvements on the property using the same building materials and method of construction.

If you’ve got money to invest in property, there’s more than one option open to you.

You mostly hear about people buying a house, doing it up and then selling it on or renting it out.

But you could also do the same with property abroad. Or an increasingly popular way to make money is by renting property to businesses.

New research by lenders Mortgage Trust shows more than one in four landlords are looking to get into corporate rents, which includes commercial buildings as well as leasing domestic properties to executives who have moved from other parts of the UK.

At the start of 2007, that figure was just 14 per cent according to its research. Now it stands at 27%.

Much of this growing interest is because you can make more money renting property in this way, especially if you can afford to buy a commercial building.

Businesses tend to demand high standards. And if you can provide, they will pay handsomely for it.

On top of higher rents, a company is much more likely to stay in a building for a longer period of time. If you think how much hassle it is for you to move house, it’s ten times the pain for a business.

When your tenant does move, they are less likely to do a runner than people renting property might do, leaving you with a mess to sort out. This is true for domestic as well as commercial rents. And businesses are more likely to put the building back to the state it was when they moved in.

Some landlords hope that down the line they can sell their investment property to the tenants.

If you are interested in buying a commercial building as an investment, you need to approach it a little differently to when you are renting property domestically.

First off you must look very carefully at the location of your potential investment, and consider the type of business that might rent it from you.

Companies that use warehousing will need excellent transport links, plus lots of cheap space. Whereas a business that has lots of staff and clients visiting the premises will be more interested in a smart looking building and plenty of parking spaces.

The trick is to find a balance between the likely cost of the premises, the features of the building and the location.

Next up you should look at the infrastructure on offer. A building will have more appeal if it has modern network cabling in place, plus a good security system. The building should already have smoke detectors and other safety features such as fire extinguishers, as these are required by law.

One smart tip that will help you maximize your profits from renting property to businesses is to look at how you can make better use of the space you have bought. For example, if you have a tall building, could you install a mezzanine floor to double the floor space available?

Is there wasted space in the loft or associated outbuildings that can be converted? The more floor space you have, the more monthly rent you will get.

It will be harder to do this work if you buy the building with tenants already in. If the building is empty it will be easier, plus you can throw the cost of improvements into any borrowing you are doing to fund the purchase price.

Finally, before you shell out for your building, find a commercial estate agent you trust to work with you as a partner. Not only will they offer plenty of advice on the best way to get a good monthly income from the building, but they may act as a property finder for other businesses – matching renters with tenants.

This could be a powerful weapon for you in marketing your new commercial building, and getting tenants renting property quickly.

Time and time again I see the same mistakes being made by real estate investors. These mistakes create a poor foundation for the investment and can cause serious financial hardship over the life of the investment. Two of these mistakes deal with improper analysis of the subject property prior to purchase, and the last mistake has to do with having a clearly defined exit plan.

1) Vacancy – Vacancy is an often overlooked, minimized, or completely ignored property cost. Vacancy is a very real part of any real estate investment and must be taken into consideration when analyzing property. Vacancy rates vary from city to city, and many times from neighborhood to neighborhood. Good property managers track vacancy rates and are a good resource to determine local rates. Typical vacancy rates range from 5%-20% of the gross scheduled income (GSI). Sellers of investment property rarely use rates higher than 5% in their sales literature, if they list vacancy at all. As such, it is always prudent in real estate investment analysis to include an allowance for vacancy characteristic of the local market.

2) Maintenance and Repairs – Routine maintenance is a natural part of any investment property and must be taken into account in your analysis. But when purchasing an investment property, the first thing to determine is if any deferred maintenance is required. Many times maintenance rates are estimated without any consideration given to the current condition of the property. It is quite common for owners to sell homes in disrepair or when they know large expenses are looming, so it pays to have the home professionally inspected prior to purchase. Maintenance rates generally run from 5% -20% of the gross operating income (GOI). Expenses tend to be higher for older houses that have not been well-maintained.

3) Exit Strategy – Exit strategy is by far one of the most important elements when purchasing investment real estate. One must assess the motives and struggles of the current owner so they can determine the likelihood of being in the same situation when they are ready to sell. Check carefully to see if you are buying in an area consisting predominantly of rental homes. If you are, your primary strategy may be selling to an investor, who will likely expect a discount. If on the other hand, your investment resides in a solid retail neighborhood, you will likely need a real estate broker to sell it. Sales costs generally range from 6-8% if you are using a broker and 1-3% if you are not. Be aware that your buyer will likely require inspections that could reveal defects that can cost thousands of dollars to remedy. Planning and understanding your exit strategy and costs are key to building a good foundation for your investment.