As you might imagine, there are many factors involved when analyzing a real estate investment. However, when it comes to determining an investment property’s value (i.e. price) most professionals first use one of two methods: (1) price per unit; and (2) income relative to price.
Price per Unit
The first way a real estate professional will underwrite a property is by looking at its price per unit. In other words, how much the seller is asking per unit of building. Each real estate industry sector generally uses a different unit:
For example, a retail property may be priced at $300 per square foot (PSF), a multifamily residential property may be priced at $250,000 per housing unit, and a luxury hotel could be priced at $500,000 per hotel key.
- Retail, Office or Industrial: Price per square foot
- Residential: Price per housing unit
- Hospitality: Price per hotel key
Because real estate is a hard asset (i.e., has an intrinsic value like a commodity), investors want to know how much per unit you are asking them to pay. Oil is priced per barrel. Gold is priced per ounce. Similarly, investors will price property on a per unit basis too. As we have mentioned previously, many real estate investors aim to purchase property at or below replacement cost (i.e., meaning how much it would cost to replace the building, including purchasing the land).
Income Relative Price
The income approach is a method used to determine a property’s value by looking at the total annual income (produced from rent and other cash flow streams) relative to the property’s price. In the case of a vacant property, the value is calculated based on the potential income, which is derived from estimated market rents of similar properties.
Analyzing a property’s value based on its income is similar to looking at the Price to Earnings Ratio (P/E ratio) of stock for a publicly traded company. With stocks, an investor looks at the company’s net income (i.e., earnings) over a 12-month period compared to the total price of all the outstanding common stock (i.e., total price). So a company that has $100,000 of annual earnings and a total company price of $1,000,000 would have a 10 P/E ratio ($1,000,000/ $100,000).
In the real estate industry, property value is calculated by dividing the income by price (the inverse of P/E). For example, a property with $100,000 of annual income at a $1,000,000 price would be equivalent to a 10% annual yield:
Net Income / Total Price = Yield
Using this equation, a property’s value (i.e., price) can be determined by taking the income and dividing by a desired yield. As an investor, if a property has $100,000 of annual income and you are happy with a 8% yield, you would be willing to pay $1,250,000 ($100,000 / .08 = $1,250,000).
Real estate industry professionals call the market yield (i.e., the average yield a property will sell for on the open market) the “capitalization rate” or “cap rate.” It is typically the first thing a real estate investor will ask when looking at a potential property: “What is the cap rate?” In many ways, it is more valuable to know what the cap rate is than the property’s total price. The cap rate immediately tells you how much annual income you might receive for every dollar you invest and also helps you estimate the amount of debt the property could afford (to be discussed in another blog post).
When valuing property, price per unit is an important indicator of how one property compares to the rest of the market, however it doesn’t tell you how much return you will earn on your investment. Hence, real estate professionals look at both cap rate and price per unit when determining a property’s value.