Everyone knows that when you want to determine the value of a property you “run the comps”, which basically means you look for similar properties that have sold or are for sale as the basis for putting a value on another property that you are interested in either buying or selling. It’s a very appealing concept because it sounds so scientific.
So when investors look to buy or sell an investment property they often want their realtor to “run the comps” and many realtors are more than happy to oblige. There is only one problem. When it comes to real estate investing running comps – at least in the traditional sense of looking for a similar structure – really doesn’t make a lot of sense.
First, it’s usually pretty hard to find truly comparable properties because there are so many variables involved: size, location, condition, type of structure, level of finishes, age of finishes, etc… I really believe it’s usually harder to find good comps for investment properties than it is to find comps for single family homes. Yeah, you can try but you are going to end up with a mish mash.
More importantly sophisticated buyers don’t just look at the structure of an investment property to determine its value. In fact, that is subordinate to the financials because at the end of the day they are looking at an investment and all that really matters is how much money are they going to put in and how much are they going to get out every year. Therefore, what it really comes down to is what price is going to give investors the return that they are seeking. It’s basically the same as pricing a bond, which is based upon the yield that investors want.
So you should throw traditional comps out the window and instead focus on the returns that investors got on recent purchases in the area and then figure out what the property in question needs to sell for in order to achieve a comparable return. In other words you are comping returns instead of buildings. And one of the benefits of this approach is that you don’t have to find similar buildings since investors primarily focus on the return on investment.
However, as I’ve pointed out in a previous post, real estate investors have a variety of metrics that they use to evaluate their return on investment: Real Estate Investing 101: What Are Your Financial Goals? So what metric should you use to compare the sales prices of different properties? Most of the time it’s going to come down to cap rate or occasionally someone might look at the gross rent multiplier.
Therefore, we might calculate the cap rates at which other area properties sold and then value the property we’re concerned with at a similar cap rate. For instance, if area buildings seem to sell with cap rates of around 6% and our building has a $30,000 annual net income then it’s worth about $500,000 since 6% of $500,000 would be $30,000. The value might be adjusted up or down from that depending on it’s condition and what sort of additional investment might be required in order to achieve that net income in the long run.
Notice that I’ve been talking about looking at returns in the area. The reason for that is that different areas around Chicago are going to offer different returns – on paper – to adjust for differences in the cost and risk of doing business in an area. Whereas investors might be happy to get only a 5% cap rate in Lincoln Park they are going to want a much higher rate in Englewood. And within a given area the valuations should produce fairly consistent cap rates between properties.
An Example Of Misguided Investment Property Comps
A few weeks ago I attended a seminar hosted by another realtor and a mortgage lender. The lender was trying to make the case for how hot the real estate market was by telling the story of a 3 unit building that recently sold. In the lender’s version of the story the realtor had “run the comps” and came up with a price of $649,900. Within days they were overrun with like 25 offers. They rejected all the financed offers and asked the all cash buyers to return with their best and final offer. The building sold for $850,000.
Guess what? That story is total nonsense. From the lender’s description I was able to determine that the building was at 1214 W Ohio. The outcome has nothing to do with a hot real estate market and everything to do with a badly mispriced property as a result of looking at comps instead of returns. At a price of $650,000 the cap rate was well in excess of 9%, which is unheard of in that neighborhood. No wonder they were overrun with offers. Even at $850,000 the cap rate was probably in excess of 6.8%. If they had looked at this from the perspective of investment returns that whole mess could have been avoided and the seller might have gotten an even higher price.
Gary Lucido is the President of Lucid Realty, the Chicago area’s full service discount real estate brokerage. If you want to keep up to date on the Chicago real estate market, get an insider’s view of the seamy underbelly of the real estate industry, or you just think he’s the next Kurt Vonnegut you can Subscribe to Getting Real by Email using the form below. Please be sure to verify your email address when you receive the verification notice.