Valuing Foreclosure Properties
To determine the value of a foreclosed property you'll need to learn how real-estate professionals evaluate a property's current value. You must learn to read and understand operating statements and comparable sales. The operating statement summarizes the income producing capacity of the real estate. Comparable sales are the recently completed transactions on similar properties sold in your farm area. While there are advanced courses available that teach how to place a precise value on a property, you can learn how to determine your own values without a lot of effort using a simplified appraisal theory.
Simplified Appraisal Theory
The appraisal theory is the process by which three value measures are applied to measuring the fair market value of any particular piece of real estate. The three measures are, income approach, market approach, and cost approach
Income Approach
The income approach involves analyzing the property's operating statement. The operating statement is a summary that contains important information for the real-estate investor. Operating statements are a synopsis of the income and expenses the property produces and are sometimes called the P&L (as in profit and loss) sheet.
Here is a typical operating statement.
Monthly |
Annual |
Percent of Gross |
|
Unit 1 |
$600 |
$7,200 |
54.50% |
Unit 2 |
$500 |
$6,000 |
45.50% |
Gross income |
$1,100 |
$13,200 |
100.00% |
Vacancies |
-$660 |
-5.00% |
|
Adjusted gross income |
$12,540 |
95.00% |
|
Operating Expenses Taxes |
$1,580 |
13.00% |
|
Insurance |
$382 |
3.00% |
|
Electric |
$450 |
3.00% |
|
Natural gas |
$1,360 |
10.00% |
|
Water & sewer |
$515 |
4.00% |
|
Repairs/maintenance |
$1,200 |
10.00% |
|
Lawn service |
$600 |
5.00% |
|
Snow removal |
$550 |
5.00% |
|
Trash removal |
$950 |
9.00% |
|
Miscellaneous |
$1,000 |
10.00% |
|
Total expenses |
$8,587 |
68.00% |
|
Net operating income |
$3,953 |
32.00% |
Your ever-expanding knowledge of the local market (through your market research) will allow you to detect numbers that do not make sense on the operating statement. For example, annual maintenance should be approximately 5 percent of the property's gross income.
When you are finished you will have a pretty good idea of the value of the property based on the income approach.
Market Approach
The market approach is the process of accumulating and then evaluating recent comparable sales of similar real estate. You know if the property is a good deal from verifiable sales data.
Often called comps (for comparables), you simply compare other recently sold properties to the foreclosure property. Always remember to compare similar properties. For example, a three-bedroom, two-bath, one-story property should not be compared to a three-bedroom, two-bath, three-story property.
Cost Approach
The cost approach is the third measure of value. The cost approach estimates how much it would cost to find a piece of land just like the foreclosure property and build the same building. A depreciation adjustment is made to reflect that the building being evaluated is not new. The cost approach is most effective for those properties that do not have information readily available for the market approach or the income approach. For example, a church building does not produce income, and there are not enough recent sales of churches to make an accurate determination based on comps. Insurance agents can often help with replacement costs. Older buildings often have features or characteristics that cannot be duplicated.
You can verify some of the data on an operating statement from public information. Property taxes and many utilities (electricity, natural gas, and sewer and water) are public information that you can readily confirm. Your insurance agent can quickly provide an estimate of insurance.
Evaluating the Property after Calculations
Now that you know how the pros place values on properties, it is time to apply these techniques to real-world examples. Assume the foreclosure property you want to purchase is available at $100,000. You believe the property's fair market value is $125,000 to $130,000. Look at all three valuation approaches:
Using the income approach, you determine this property's annual net income to be $8,000 per year. On a $100,000 investment, this is an 8 percent return not including any appreciation.
Using the market approach, other recent comps affirm the property to be in the range of $125,000 to $130,000.
Using the cost approach, the replacement cost is $100,000 and the land is worth another $60,000.
From all indications, the purchase of this property for $100,000 seems reasonable.
You will also use other determinations to value property quickly. For example, one fast rule of thumb is to learn what the property costs based on square footage. If properties in a particular neighborhood are being sold for $90 per square foot, you can assume a property offered for sale at $150 per square foot makes little sense. You will also be able to quickly spot a potential bargain if the square foot price is, for example, $75 or less. This type of fast valuation is something you will learn over time as a real-estate investor buying foreclosure properties. There are always exceptions to this simple valuation method, yet it will tell you quickly if the property deserves your further attention or if it is one to pass on.
