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Real Estate Valuations 101: Why Are They Important?

by David Pascoe

If you’ve been looking into real estate investing, you’ve undoubtedly come across the term “real estate valuations.” This term can have multiple different meanings, depending on the context. You can calculate the valuation using the comparable sales method, the income approach, or the costing approach, and each method has its use for different areas of real estate investing.

Without further ado, let’s explore what each type of valuation is and when you may want to use it.

Comparable Sales: The Most Common Of The Real Estate Valuations 

When you buy a house, the bank will order an appraisal. They will contract someone to come out, take a few photos of the place, get some details on it, and look at the prices of some other homes in the area that have sold. Of course, those homes won’t be exactly like the one you want, so they’ll adjust those prices up or down, within some guidelines, to account for those differences. After making those adjustments, the appraiser will come back with a fair market value for your property.

This method assesses the value of the property by looking at what others have paid. For example, if everyone else is paying for $300,000 for a two-bedroom home in the area, then your two-bedroom property is probably around that price. You’ll see this valuation method when you go to buy a new home.

Income Approach

The other way to value a property is to look at its income potential. A home that makes $1,000 in monthly rental income is less valuable than one that can make $10,000 a month. 

There are some formulas to obtain an absolute valuation based on potential income. One of these is the direct capitalization formula, where the home’s value equals annual net operating income, divided by the cap rate minus the growth rate. There are other, more advanced, ways of calculating real estate valuations based on the income potential of a property.

As you might expect, investors use this approach when trying to determine the value of a potential investment.

Cost Approach

The last and final method of valuing real estate is the cost approach. As its name implies, this method sets the value at the expense you would incur to replace the property. It combines the value of the property’s structures (e.g. the home itself) plus the value of the underlying land. So if the space was worth $250,000 and the house would cost $100,000 to replace entirely, then the cost approach would value the property at $350,000.

In some jurisdictions around the world, governments use this approach to calculate property taxes. 

Which Of The Real Estate Valuations Is Important To You?

As a real estate investor, the essential valuation metrics are the comparable sales (as this will guide the amount you should offer) and the income approach. You shouldn’t be overpaying for properties, and any investment you do make should provide a positive income stream.

At Australian Property Investments, we work with investors with a wide variety of different goals. We can calculate these valuations for you so you can have confidence that you are making the right decision!

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