Real Estate Investing: The Four Values

Most small to mid-size real estate investors are forced to rely on “comps” for their valuation of a potential investment.  This is the method commonly employed by appraisers and the real estate industry as a whole so it’s really been the only choice available… until now.  If you are a regular reader, you know I have found the existing tools in real estate to be inadequate for the needs of myself, my partners and my clients.  The following is an explanation of how I value properties when we are deciding which property to write an offer on or where to cap our offer price.

CMAs
Over the past six months I have been discussing with my partner Brian Brady different ways to value a property.  Having both come out of the securities field (I enjoyed some pretty exciting [read: stressful] years as an options trader – he was a bond trader), our discussion revolved around how property would be valued if it were a security investment.  First, a Comparative Market Analysis or CMA – which is based on comparable properties or “comps” – would be used only as a qualifier or a secondary validation.  They are circularly self-serving and relationally compromised.  Instead of comps, we should be looking at a more financiallyuseful value.

A New Method
There are actually four values to any property.  The first may be interesting, but is not often directly helpful for our investments.  The next three should, however, be calculated every time we look at a property.  Here are the four values in ascending order:

BREAK-UP VALUE – this is the value of the land itself along with any profits to be made selling pieces of the home before tearing it down, minus the cost of tearing it down.  In Illinois, for example, there are companies that advertise a home about to go under a radical rehab.  Buyers come to the home and everything is auctioned off: staircases, doors, windows, cabinets, etc.  After such an auction you combine the money in your hand plus the value in your land and subtract the expected cost of your demo contractor to arrive at the break-up value of your property.

INTRINSIC VALUE – this is the value of the land plus the actual cost to build a model match home using today’s material and labor costs.  Don’t forget the fees, permits and so on plus the potential for temporary housing costs incurred while building the home  (loss-of-use cost).  This is most often calculated by ascertaining the value of the land itself and then multiplying a “per square foot” cost for construction.  (Your local General Contractor can give you such a number.  As always, try to find three “per square foot” costs and average them.)  Total those costs and you know what a property is worth intrinsically.

FUNDAMENTAL VALUE – this is the value of most importance to an investor.  It is calculated using comparable rents for the neighborhood in relation to a property’s cost-of-carry.   It is the KEY to correctly valuing an investment property.  Once calculated we have little trouble knowing what financing is going to look like and whether the deal is a money maker.  This is how non-owner occupant investors would evaluate a property.  “Does it pencil out” is another way of asking the property’s fundamental value.  This kind of analysis will also tell us when prices are out of line.  (Details on calculating this value can be found here.)

UTILITARIAN VALUE – this is the Fundamental Value plus the non-specific value that accrues to a person owning their own home.  Brian Brady jokingly refers to this as the “purple wall” value: the added premium a person is willing to pay for the freedom to paint the walls of their home purple.  While not easily calculated; it is often easy to quantify.  Look at any area where “fixers” are being sold.  You will find a price discrepancy between what investors will pay who wish to make repairs and still earn a profit (either monthly or as a flip) and someone who actually wants the home for their own.  When you are bidding on homes to rehab and/or flip as an investor, your price is based on #3 (Fundamental Value) and you should never compete with someone looking to make it their own home because they will pay the utilitarian value.

Conclusion
Using these four valuing methods, we can make informed, rational decisions (even while missing out on some of the run-ups) that should leave us financially sound in the long term.  An investor’s comfort with and use of the fundamental valuation will, to a large degree, determine that investor’s long term profitablity.

Filed under: INVESTORS, Break-up Value, CMAs, Fundamental Value, Intrinsic Value, Property Value, Real Estate Investing 101, Utilitarian Value