How To Value Real Estate

by Mike Holman

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Valuation of real estate properties is quite difficult – in fact it can really only be done within a fairly broad range since in my opinion it is just too hard to try to accurately predict the sale price of a house.  The title of this post should have been “How to guess at real estate prices”.  :)

A few years ago I spent a lot of time looking at various houses, taking notes and finding out the eventual sale price.  The reason I did this exercise was partly because I enjoyed going to open houses but also because I knew I was going to be in the market for a new house and I wanted to learn the market better.  My theory regarding house valuation was that if I looked at enough houses and analyzed the different properties and the sale prices – I should be able to gain some sort of expertise and should be able to accurately predict the value of various houses.  My theory was a failure as I couldn’t seem to gain much accuracy for various houses that I tried to predict the sale price.

I was able to learn the local housing market to some degree but if I could guess within 10% of the final price then that seemed to be as good as I could do.  A plus or minus 10% error on a $500k house is not all that useful although I was able to know when sellers set the price below market for a bidding war.  Of course I couldn’t tell what the final price would be.

Look at lots of houses

The best advice that I have for a house hunter is to look at as many houses as they can, take notes (or keep the mls listings) and find out and write down the final sale price.  The purpose of doing this is to learn the local housing market and get a feel for what kind of house will go for various prices.  You might be asking why this is necessary if you have an agent….well…..this post might give you a clue!  I think a good agent who knows the area could be a great resource as far as knowing house valuations but unfortunately not all of them will be forthcoming if they aren’t familiar with your area.  If you have the time, then the best strategy is to learn the local housing market yourself.

This also applies if you are selling your house.  In fact it’s easier to do if you are only looking at houses similar to your own since there probably won’t be that many of them.  This is useful to try to set an asking price and also to counter your agent who will generally have different ideas than you about selling prices.

Land can be a huge factor.

One of the “truisms” of real estate that everyone always says (to me at least) is that detached houses command a premium over semi-detached.  While I can certainly accept this as being true, I’ve always been skeptical that there is much of a premium involved.  After all, other than the fact that a wall is shared, the house can be very similar to a detached.

As a bit of background – in my area there are probably 65% semi-detached houses and 35% detached houses so unlike some areas, there is nothing “unusual” about a semi.   It’s also a very urban setting so land values are quite high.

More background – for any American readers -  what I call “detached” (standalone house having no contact with any other structure) you might call “a house”.   What I call “semi-detached” you probably call “duplex” or “semi-attached”.

Detached/semi-detached was one of the “factors” that I tried to analyze in my great house valuation project.   After looking at quite a few houses, I really couldn’t see any premium for detached.  Part of the problem of course was a difficulty in finding houses that were similar in many respects except for the detached component.  I concluded after a while that the detached premium was probably low enough (<5%) that I couldn’t measure it properly.

It wasn’t until much later that I realized how high the land value was in the areas I was looking at.  Since most of the houses were in reasonably good condition (for old houses) I had assumed that buyers were paying quite a bit for the house along with the land.  As it turns out the buyers were generally paying a huge percentage for the land and a surprisingly small amount for the house.  I figured this out by eventually looking at some houses that were teardowns or complete guts.  Since the house was worth very little in those cases, clearly the buyer was just paying for the land.  In one particular area I looked at – most houses were selling for around $450k.  Much to my surprise, there were a few houses purchased for around $350k, $360k that were torn down which leads me to believe that $450k houses were in fact only $100k houses sitting on $350k pieces of land.

What does this have to do with detached/semi-detached?  Well, given that the land value was such a dominant factor in my local house prices, that meant that any premiums/discounts on the houses themselves are minimized.  Ie if the detached premium is 20% but the house is only worth $100k and the land is worth $350k then a semi-detached equivalent would be worth only $20k less which I wouldn’t be able to measure.

Of course semis are different in that it’s a lot harder to tear down a semi unless you buy both halves so it’s not accurate to say that the land under a semi has the same worth as a similar sized plot under a detached house but I’m assuming it’s close enough.

I have some other main “factors” which I think contribute to house prices which I’ll hopefully share in a future post.

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{ 16 comments… read them below or add one }

1 Mr. Cheap

Very interesting post! Perhaps your 10% margin of error represents irrational buyers / sellers rather than limitations of your analysis / valuation.

Real estate appraisal is certainly more art than science…

2 Mike

Hmmm….I hadn’t thought of that.

I think the error is mainly from too many variables and not enough data (and quite possibly not enough brain power). The irrational buyer/seller is a great point however which I’ll have to mention in my followup post.

I did this “research” mainly in 2004/2005 when 10-15% annual gains were the norm so it definitely was a factor.

3 Canadian Capitalist

I’m not a real estate investor but I’ve looked at some rental units and I use the cap. rate as a measure. Looking at gross rentals, it just doesn’t seem all the appealing to me — it seems to me that most rental real estate investors are counting on capital gains to make their profit. If I have to rely on capital gains, I’d prefer stocks.

4 Four Pillars

CC – Most real estate investors that I’ve read about or talked to are in love with the idea that the renters “are paying my mortgage for me”. That seems to be the extent of their analysis.

5 Mrs Pillars

Um, having someone pay my mortgage for me actually sounds pretty good. What’s not to like?

6 guinness416

Mike, I think there is a frustrated real estate agent inside you just waiting to get out. We’re detached (which given my bad temper and dodgy taste in music is good) but our next door neighbour is planning to add a second floor to her bungalow which I’m a little nervous about.

Torontoist had a really interesting post about buying property on the islands today, you guys should blog your opinion on that.

7 Four Pillars

Mrs. Pillars – The long answer would require a post which I think I will do.

Short answer – It’s very possible to buy a rental house, have the renters pay off the mortgage and have a very poor return for your investment. As CC said, this method relies on the house value going up significantly which will take advantage of the leverage being used.

Owning a rental property is fairly high risk because of leverage plus no diversification. It can also be time consuming. You also have to account for maintenance on the house.

There has to be a high enough return to justify the effort and risk involved otherwise it’s not a good investment.

8 Four Pillars

Guinness – I wouldn’t worry about the neighbour’s second floor too much – it should help your property value. It might be noisy for a while though.

Great article on Toronto Island homes – as one of the commenters said, it’s like being on the Leaf’s season ticket waiting list.

This is blog-post-worthy for sure. I have to admit that I don’t understand why these homes are “protected” – what’s wrong with just selling them on the open market? Our city has a major budget shortfall and some extra cash could come in handy.

Here is the post link:

http://torontoist.com/2009/08/how_to_buy_a_house_on_the_toronto_islands.php

9 jesse

The quickest way is to look at cap rate, especially for condos where the capital structure dominates the price. Here we should be expecting an immediate return commensurate with the effort and risk.

Properties with a larger land component like a detached bungalow will have a premium compared to rent (i.e. lower cap rate) if the neighbourhood is generally increasing in density in the near future. Then it’s the POTENTIAL FUTURE, not current, income of the land that will set the price, including re-development costs of course.

For example a small bungalow on a large lot surrounded by quadriplexes in a desirable neighbourhood will have a justifiably high price-rent ratio because upon sale it will most likely be re-developed.

Using cap rate or other similar discounted cash flows calculations is fine but it also relies on the absence of speculative credit bubbles. This is clearly not the case today; condos’ cap rates in many Canadian cities are low compared to other investments with similar risk and capital structures. The best you can do is look at comparables and compare it to other options available to you. In many cases, the correct answer is to overpay.

10 Bud

Rental duplexes are one of the worlds best investments that will survive inflation or depression. During depressions some people still have jobs and want to own their house. What better house to have during a depression than one where some one else is supporting to the mortgage. The stock market is a crap shoot where money is lost if some foreign country incident emerges, or if there is a strong wind from the south or if the president of the U.S.A. gets the flu. Conversly, real estate fluctuates slowly from time to time but always moves up. My first home cost $10,000 and would now be $200,000. During dips in the housing market fewer new houses are built which supports rentals.
Exceptionally double digit high rates of return are possible from good properties.

11 Seacloud

While most of the comments ahead of me are about rental properties, I wanted to share with you my ‘epiphany’ moment where I realized the balance of land vs. house value. After we bought our first home we, of course, needed home-owners’ insurance. Looking at the limit values on the insurance policy makes it pretty clear where the value of the house is relative to the price we paid for house and land (at least, in the eyes of the insurance companies).

12 Four Pillars

Seacloud – yes, that’s a good point about the insurance replacement value.

And don’t forget – that’s for a new house. If the house you bought is old it might only be worth half of the replacement cost or less.

13 Bud

Certainly the value of the land is a major component of the value of the property. That is supported by the old saying,n “The three most important factors influencing the cost of real estate is LOCATION, LOCATION, and LOCATION. My parents bought a three bedroom bungalow in the Bayview York mills area of Toronto for $120, 000, lived in in it and enjioyed it for many years and solld it for $670,000. The buyer tore down the house and built a monster home on the 63 ft. lot. that created a million dollar value address. Wasn’t it will Rogers who said, “Land is a great investment, they don’t make it anymore”. Think about how that relates to the limited supply of water front property close to urban districts, property that increases in value 8 to 10 times faster than land locked property be it residential or commercial. Really, beyon the cost of insurance premiums, who cares about the break down bvetween land and building, they become a packagewhen linked together and the packaged is va

14 qmanrei

Real estate value is what someone is willing to pay for a property and what someone else is ready to let it go at.

If you are looking at factors that drive up or down the value of real estate then that is something different. You need to look away from the house itself and look at the economic fundementals of the area, diversity of jobs, in-migration, wages above the provincial average and so on.

If you are buying real estate as an investment Cap Rate is just one anayltic tool. Cash flow is extremely important in all our deals, although we use a number of different strategies. Mortgage paydown and appreciation are bonuses, albeit well paying bonuses. As well as owning a physical asset provides inflationary protection, and tax incentives.

Risk is perceptional as well as situational. We have a number of properties that we manage and control. I would say there is less risk to us than if we were to use another investment tool. With MERs and CEO perks, and the like.

I enjoy the blog :)

15 MIB5

Hey just curious, how were you able to confirm the sale price. I thought a Realtor could only access that info. TIA, MIB5

16 Mike

MIB5 – you can find out a number of ways. I used to have access to a MLS login which was extremely cool.
Other methods are to sign on with an agent and ask them to look up sale prices. I’ve also just phoned the selling agent after the sale – they’ll generally tell you although you might just get a range.

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