There was a forum question that caught my eye the other day. Basically, the question asked, “Should the useful life of a fully renovated house (little future cap ex) have a bigger influence on the property’s appraisal than recent sales in the area?”
The post was in regard to turnkey properties in areas with low comps. The quick response he got was, “If the property doesn’t appraise out, you shouldn’t buy it.” Which I think in general is a good rule, but I want to address here that it isn’t just that simple. The value of something is all a matter of perspective. So you have to remember whose lens you are looking through.
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How Are Single-Family Homes Valued?
Single-family homes are valued via a comparable sales approach. An appraiser will go out and take a look at the property and compare that property to other properties that have sold in the area. He will make various adjustments to try and create apples to apples comparisons.
Why is This?
Owner-occupants buy the vast majority of single-family homes. So the value of the property is reflected from the perspective of the owner-occupant. How much will someone pay to live in this house in this neighborhood? And when they’ll be going to sell, how much will another owner-occupant pay to be in this neighborhood? The owner-occupant sets the market because they are the consumer. So the comparable sales approach is a snapshot of the market. It shows the value of a house relative to other houses in that neighborhood. It is market value for owner-occupants.
But who is really setting that value? Most would say other homebuyers, but I would argue that it isn’t them. It is the banks. The banks have the final say on whether the price the homebuyer pays is appropriate because they are supplying the majority of the money. The bank is out to protect its interest. They will not lend on a property unless the amount they are lending is less than the appraised value. When you look at it from the bank’s perspective, it makes sense. The bank is only looking at the value from the eyes of an owner-occupant.
What is the Value of a Property From an Investor’s Point of View?
An investor is going to value the property from an investment point of view. They treat it as though it was a commercial property. They look at the yield of the property. The amount of money invested versus the amount of money that gets returned. The value of the property is derived from the yield that someone is willing to accept, and this value can be very different from the appraised value.
Let’s try to understand this by using an example of a property in Beverly Hills. It shows the property sold for $1,950,000, and they are trying to rent it for $8,900 a month. This comes in at 0.45%. As a cash flow investor, depending on which rule you use — 1% or 2% — you wouldn’t buy this house. As a 1% investor, you would pay $890,000 and as a 2 percenter, you would be down at $487,500 for that property.
A cash flow investor would value that property very differently. There is a big gap between what the appraised value may be and what the investor’s value is. In this instance, it wouldn’t be a problem for an investor to get a loan on this property if he were able to hit its numbers.
On the other end of the spectrum, when you look at low priced homes in C or D-class neighborhoods, sometimes the appraised value will come in below what an investor may be willing to pay based off of the return. This doesn’t mean their value is wrong; it just isn’t in line with how the banks value single-family homes.
Appraisals are there to protect banks from overzealous homebuyers, which in turn protects homebuyers from overpaying for a property. I personally don’t think an investor should necessarily pay over the appraised value, but there may be some instances where a sophisticated investor may see more value in a property than what the appraiser may.
Do you invest in single-family homes? How do you calculate their value?
Let me know with a comment!