Real Property Valuation In Washington DC
Section: Investor Intel
Author: Susan Isaacs, Washington DC Real Estate Strategist
Property Valuation is the present worth of future benefits arising from its ownership.
This definition refers to the fundamental idea that the value of an investment property is determined by the cash flows and benefits it is expected to generate in the future, and these future benefits are brought to their present value.
Key components
Present Worth: This term indicates that the value is expressed in today’s terms, taking into account the time value of money. In other words, future cash flows and benefits are adjusted to reflect their current value, considering the concept that a dollar received in the future is worth less than a dollar received today due to factors like inflation and the opportunity cost of investing that money elsewhere.
Future Benefits: This refers to the income and financial returns expected to be derived from the ownership of the investment property. These benefits can include rental income, potential appreciation in property value, tax benefits, and other income streams associated with the property.
Ownership: The valuation is based on the assumption that the property is owned and used for investment purposes, such as rental income or capital appreciation, rather than for personal use.
In practical terms, the valuation of an investment property involves estimating the expected future cash flows and benefits the property is anticipated to generate over a defined period, typically several years. These cash flows are then discounted back to their present value using an appropriate discount rate. The discount rate takes into account factors like the property’s risk, the cost of capital, and the desired rate of return for the investor.
Here’s the formula for calculating the present worth of future benefits:
Present Value = Sum of (Future Cash Flows ÷ (1 + Discount Rate)^n)
Factors:
Present Value is the value of the investment property in today’s terms.
Future Cash Flows are the anticipated income and benefits from the property over the investment horizon.
Discount Rate is the rate used to discount the future cash flows to their present value.
n represents the time period at which each future cash flow occurs.
Step by step:
Add 1 + the discount rate
Raise this number to the power of 1 (=1 year into the future)
Divide the future cash flow by the result
By calculating the present value of these future benefits, investors can determine the estimated value of an investment property based on its income-generating potential and the time value of money. This valuation method is an essential tool for real estate investors to make informed decisions about property acquisitions, sales and investment strategies.
Why Learn About Property Valuation?
A successful investment outcome begins with valuation. Before you buy a property, you’ll need to know its worth in the marketplace, to lenders, and to your portfolio. Accurate valuation is key to forecasting your ROl, ability to borrow against the asset (loan values + equity), and in planning for carrying costs and overhead. It is also useful in evaluating ongoing performance of properties in your portfolio, pinpointing opportunities for improvement or areas of concern.
Investors should seek professional appraisals prior to submitting offers, but understanding basic valuation methods saves time when deciding if a property is a good candidate for expenditure of time and funds for further evaluation.
There are a number of these methods, metrics and calculations used in property valuation. Here are some typically utilized in the Washington DC market:
Property Valuation Methods For Investors
Property valuation is the trickiest and riskiest step in an investment property purchase. The amount you pay for an investment property impacts its use and potential throughout the ownership term.
Learn about the four commonly-used methods for investment property valuation and decide which one applies to your property.
Cost Method
The Cost Method provides a simplistic valuation: the sum of the estimated land value + depreciated cost of the structure(s) and other improvements. The formula looks something like this:
Property Value = Land Value + Cost New – Depreciation
Cost Method holds that property should be priced equally to the cost of constructing an equivalent building in the same location, considering the value of the land & site improvements, subtracting accrued depreciation.
There are some drawbacks to the Cost Method:
It expects that users have access to reliable cost accounting for the subject property and comparables
It doesn’t account for post-construction value, which may be considerably lower or higher than original cost.
Income Method
The Income Approach is the most involved and difficult method of investment real estate valuation. It relies on the property’s generated income to estimate market value. The formula looks something like this:
Net Operating Income ÷ capitalization rate
Since this method is based on converting future income into current value, a primary disadvantage are the many variables related to future income. For example;
Condition of the property can affect future profits if significant repairs are needed
The property may not be operating as efficiently as it could be, have a low occupancy rate, or delinquent tenant accounts
Collected rent must be greater than current expenses in order for the property to be a viable purchase.
These are just a few examples of variables that can impact the Income Approach to valuation.
AI Method
Predictive Analytics for real estate investment is a new and increasingly popular method of valuation. It can:
Predict housing trends
Predict locations likely to be in high demand for multifamily and commercial properties
Configure long-term ROI of investment properties
Calculate optimal timing for purchase or sale of property
Predictive Analytics leverages property-specific factors, historical data and market trends, utilizing statistical algorithms and machine learning techniques to forecast future values. Variables like location, property characteristics, recent sales data, and market conditions contribute to valuation estimates.
Cons of the AI Method:
Unexpected or undocumented factors can adversely impact AI valuation. It has difficulty assessing the value of properties in markets such as the District of Columbia, where inventory often sells ahead of comparable data and a significant portion of transactions occur off-market
May not assess unusual or luxury-level properties well. Does not have the ability to analyze the value of shell properties, those in below-standard condition, or properties with drawbacks that need to be experienced by a human to be understood.
Property Valuation Metrics For Investors
Learn about the most commonly-used metrics for investment property valuation.
Mortgage Payment
Required Down Payment
Qualifying Rental Income
Price To Income Ratio
Price To Rent Ratio
Gross Rental Yield
Cap Rate
Cash Flow
Want to learn more? Here’s an Investopedia article
Property Valuation Calculations For Investors
Valuation skill is a key component of your real estate investment strategy. The better real estate investors understand this process, the more exact their evaluations of potential portfolio additions, performance of existing properties, and areas requiring improvement will be. And that equals profit.
Here are the most commonly-used calculations for investment property valuation:
NOI
NOI (net operating income), is used to determine the profitability of an income-generating property.
Total revenue vs. the total operating expenses of a rental property
Income from includes sources such as rent, parking, storage fees, recreation fees, on-site laundry and vending revenue, etc.
Operating expenses include maintenance and repairs, property taxes and insurance, property management fees, janitorial services, and utilities. Capital expenditures, such as costs for a new air conditioning system for the entire building, are not included in NOI.
Applications
NOI is also used to calculate CAP rate, DCR, net income multiplier, cash return on investment, and total return on investment.
Start with Gross Operating Income (GOI). This includes rent, fees, etc. Subtract overhead and costs:
Insurance premiums
Utilities and services
Property taxes
Recurring maintenance/upkeep
Repairs and replacements
Personnel
NOI = Gross operating income – operating expenses
*Also consider non-recurring CapEx (capital expenditure) not included in NOI calculation. This could be a roof or HVAC system replacement, plumbing or electrical system upgrade.
CAP Rate
The capitalization (CAP) rate indicates the property’s basic rate of return based on the projected estimates of future income.
To calculate a property’s CAP rate, divide NOI by the property’s total cost:
Cap Rate = NOI / Property’s Total Cost
The rate also provides the amount of time needed to recoup the amount invested. For example, a property with a cap rate of 10% will likely have a 10 year recovery timeline.
What is a good cap rate for an investment property?
A range of 5% to 10% is typically considered a good cap rate for an investment property, but this can vary significantly market to market, with different property types, and depending on the investor’s strategy.
Lower CAP rates (4-6%) suggest lower risk due to higher property values relative to income, while higher rates (8-10%+) hint at greater potential returns, but with higher risk.
These are ‘rules of thumb’ only. Whether or not a CAP rate is “good” or “bad” depends largely on variables such as the property and the market.
It’s important to understand that CAP rate represents the yield of a property over a single year, based on a cash purchase. This very basic metric should not be used as the sole indicator of the property’s potential since it ignores leverage, the time value of money, and future cash flows from property improvements, among other important metrics.
More details on CAP rate
Discount Rate (DCR)
The Debt Coverage Ratio (DCR), AKA the Debt Service Coverage Ratio (DSCR), is a key metric used in real estate and corporate finance to assess a borrower’s ability to service their debt obligations.
DCR measures a property’s cash flow available to pay current debt obligations such as principal, interest and lease payments.
Calculate DCR using this simple formula:
Debt Coverage Ratio = Net Operating Income ÷ Total Debt Service
Lenders and their underwriters like to see a DCR over 1.25 to 1.35 to demonstrate the existence of a buffer against unexpected expenses or a decrease in revenue. The DCR will be a major factor in determining the maximum loan amount and interest rate for a loan.
Investors use the DCR to evaluate the profitability and risk associated with a potential real estate investment.
Determining your DCR for investment property valuation involves a combination of factors and considerations specific to the property and the investor, so there’s not a single formula. Discount rate is typically determined for investment property valuations by considering:
Risk Assessment: The risk associated with the investment property is a significant factor in determining the discount rate. Properties have varying levels of risk. A stable, income-generating property in a prime location might have a lower risk compared to a property in a less desirable area with uncertain rental income, or in a developing neighborhood without a solid rental history. The higher the perceived risk, the higher the discount rate should be. Risk factors include market conditions, property condition, location, and tenant stability.
Required Rate of Return: Investors have specific expectations for the return they require from an investment to justify the risk. This required rate of return is often based on the investor’s investment objectives, such as income generation or capital appreciation. The required rate of return should reflect the opportunity cost of investing in this property versus other investment alternatives.
Market Conditions: The broader economic and market conditions also play a role. The prevailing interest rates in the market can influence the discount rate. When market interest rates are high, the discount rate for an investment property may also be higher.
Financing Structure: If the property is financed with debt, the cost of debt (interest rate on loans) and the proportion of financing (debt-to-equity ratio) play a role in determining the discount rate. The weighted average cost of capital (WACC) is used to account for both equity and debt financing and can be used as the discount rate.
Investment Horizon: The time horizon over which the future cash flows are being evaluated can affect the discount rate. Longer investment horizons often involve higher uncertainty, and this can result in a higher discount rate.
Comparable Properties: Comparing the subject property to similar properties in the market can help in determining the appropriate discount rate. If there are recent transactions or market data for similar properties, this information can be useful in estimating the discount rate.
Investor’s Risk Tolerance: An investor’s individual risk tolerance and investment goals can also influence the choice of the discount rate. Some investors are more risk-averse and may use a higher discount rate to account for that risk.
Real estate investors often use a combination of quantitative analysis and expert judgment to determine the discount rate for investment property valuation. This process can be somewhat subjective, and the discount rate may be adjusted based on the specific circumstances of the property and the investor’s preferences. Determination of DCR is critical to property valuation, and small changes in this metric can impact the calculated present value of the property significantly.
CoCR
Cash on Cash Return calculates cash income earned only on the cash (out-of-pocket expense such as downpayment, financing & transaction costs, etc.) invested in a property, measuring the annual ROI made relative to the mortgage amount paid over the same year. It is calculated on a pre-tax basis.
The formula is:
NOI ÷ Cash Invested) = CoCR
Use this formula along with the Cap Rate computation to contribute to your ROI computation, and to compare investment value of multiple rental properties.
More about Cash On Cash Return
Vacancy Rates
Vacancy Rates are a key property performance metric in most investment property calculations. It helps investors determine the number of units that must be rented to achieve breakeven on investment, or for the property to be profitable.
Unrealized income potential due to high physical vacancy rate in a market with high rental demand may be an indication of issues with the property or its location. A below-average physical vacancy rate may signal rents that are below-market.
Types of vacancy rate metrics include:
Physical Vacancy Rate
Formula:
Days Vacant ÷ Days Available x 100 = Physical Vacancy Rate
Compare this rate to the avg. local market physical vacancy rate.
Economic Vacancy Rate
Economic vacancy measures collected rent totals against similar area properties.
This is valuable for determining value of potential improvements, or renegotiated rents. Economic vacancy is relevant even when a property has a 0% physical vacancy rate.
Formula (requires market rates):
Lost Rental Income ÷ Gross Potential Income = Economic Vacancy Rate
More About Vacancy Rates Calculations
Valuation Tools
INVESTOPEDIA
FORBES
FASTER CAPITAL
CHRON
SAMURAI
ROOFSTOCK
BIGGER POCKETS
FINANCIAL MENTOR
RENTOMETER
STESSA
Read The Series
The DC Real Estate Investment Compass
These articles were originally published in my Tools section at realestateinthedistrict.com. Now they live here—on DC Real Estate Channel.
Zuzu Notes
Timing and planning your house hack often involves scaling. Many property owners initially begin with a basement rental in the home they occupy, later lease the upper floor, then expand to other methods. Or simply repeat!
Start With The Basics
Whether you’re investing in DC real estate as a side hustle or full-time business, understanding the local real estate market and fundamentals is key.
How I Help
Guidance and education
Off-market opportunities
Skill, experience and resources
Assembling A Team
Having a team of professionals in place will ease acquisition and management of your investment portfolio.
Your Realtor, lenders, property manager, contractors and vendors functioning as a team can identify opportunities, speed transitions, address issues, and increase profitability.