DC REAL ESTATE VALUATION

Susan Isaacs | Compass

Methods used to evaluate investment property values in
Washington DC.

WASHINGTON DC REAL ESTATE INVESTMENT VALUES

Why is valuation important to investors, and how do valuation methods differ for investment properties vs owner-occupied homes? We break down the key factors to consider in Washington DC.

What Does Property Valuation Mean?

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.

Here’s a breakdown of the key components of the definition:

  1. 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.
  2. 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.
  3. 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:

  1. Add 1 + the discount rate 
  2. Raise this number to the power of 1 (=1 year into the future)
  3. 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.

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Bullet Points

  • Sales Comparison
  • Cost Method
  • Income Method
  • AI

Why Learn About 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 opportunites 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. Below, we share those typically utilized in the Washington DC market.

INVEST | DC Real Estate

PROPERTY VALUATION METHODS

FOR DC INVESTORS

Property valuation is the trickiest and riskiest step in an investment property purchase.

Learn about the four commonly-used methods for investment property valuation and decide which one applies to your property.

Sales Comparison

The Sales Comparison Approach (SCA), or ‘Market Approach,’ relies on the market as a gauge for value, based on interaction of supply & demand + property similarities at the time of sale. SCA utilizes recent sales & active listings. Weight is given to comparables with closest proximity, most similar attributes, and closed status. Adjustments are made to the comparable properties, not to the subject property. The Comparative Market Analysis (CMA) is an SCA tool widely used by real estate agents and appraisers. The primary disadvantage of SCA, especially in inventory-constrained markets like DC, is lack of comparable properties. Another aspect to consider–and this can be true of all valuation methods–is the samples are limited to on-market properties. In our market, a significant portion of properties are listed and sold off-market, and valuations are therefore weakened.

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 deliquent 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 such as location, property characteristics, recent sales data, and market conditions contribute to valuation estimates.

But AI has difficulty assessing the value of properties in markets such as DC where inventory often sells ahead of comparable data and a significant portion of transactions occur off-market. It also has trouble with unique properties, properties with very high, luxury-level features, those in below-standard condition, or with drawbacks that need to be experienced by a human to be understood. Unexpected, undocumented factors can seriously skew an AI valuation.

Calculations

Valuation Calculation

CAP RATE

Cap Rate (capitalization Rate) represents the yield of a property over a one-year time horizon, based on a cash purchase. The capitalization rate indicates the property’s basic rate of return.

Computed on net income the property is projected to generate, Cap Rate is calculated by dividing net operating income by property asset value:

Net Operating Income ÷ Current Market Value = Cap Rate

The result shows as a percentage. This computation is used to estimate insvestors’ potential ROI.

Used alone, Cap Rate can quickly compare the relative value of similar real estate investment properties, but is not recommended as the sole indicator of an investment’s potential since it doesn’t factor in leverage, the time value of money, and future cash flows from property improvements, among other metrics.

DISCOUNT RATE

Determining the discount rate for investment property valuation involves a combination of factors and considerations specific to the property and the investor, so there’s no blanket formula per se. Discount rate is typically determined for investment property valuations by considering:

  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. 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.
  6. 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.
  7. 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.

It’s important to note that the determination of the discount rate is critical to property valuation, and small changes in the discount rate can have a significant impact on the calculated present value of the property. Consider very carefully–and justify–the chosen discount rate when valuing an investment property.

QUICK START

ESSENTIAL METRICS

  • Mortgage Payment
  • Required Down Payment
  • Qualifying Rental Income
  • Price To Income Ratio
  • Price To Rent Ratio
  • Gross Rental Yield
  • Cap Rate
  • Cash Flow

NOI

NOI (net operating income), is used to determine the profitability of an income-generating property.

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.

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.

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

What’s Ahead?

Investing In 2024

Real Estate investment volume forecasts predict a 15% rise in 2024

Recovery from lower activity in 2023. Investors are showing renewed confidence in the market and potential for positive ROI. This projected bump in investment activity is expected to contribute positively to housing market dynamics, potentially leading to increased housing supply + price stabilization.

Interest Rates

Real estate investors are watching interest rate activity closely. Investors profit when advantageous rates lower financing costs, payments, overhead, and improve cash flow.  As inflation subsides and the Fed inches closer to its 2% goal, investors are encouraged to re-enter the market.

Buying Opportunities

Inventory is tight, putting upward pressure on the DC Market, despite diminished buyer activity due to elevated mortgage interest rates. Experts predict that the Fed will begin to cut rates in June, leading into DC’s traditionally slower summer market. June, July and August may be opportune months for investors to re-enter the market.

What lies ahead in 2024

DC REAL ESTATE INVESTMENT

Start With The Basics

Whether you’re investing in DC real estatae as a side hustle or full-time business, understanding the local real estate market and fundamentals is key.

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