Often you may hear the terms estimate of fair market values, cap rates or capitalization rate and gross multipliers in relationship to real estate. What exactly do these terms relate to or mean?
Estimates of fair market value or comparable market analysis are primarily used for residential properties and sometimes up to four unit buildings. Cap rates and gross multipliers are usually used on residential income properties and commercial property.
There are formal and informal appraisals and estimates of value. Formal appraising consists of estimating value by the collection and analysis of data. A formal appraisal analyzes factual material and reduces it to written report form so that a disinterested third party can easily review the appraisal and understand how the conclusion was reached. Usually, only licensed professional appraisers compile formal appraisals for the lenders, courts, estates, etc.
The informal appraisal is where the conclusion is reached by using intuition, past experience and general knowledge. Often Realtors look at many properties for business purposes, for one reason or another on any given day. A Realtor estimates the value of residential homes in the neighborhood they work in on a daily basis. By visually inspecting a property and doing a comparable analysis an “estimate of fair market value” can be arrived at. A good Realtor is so used to doing this that they can roughly figure out value using these methods in their heads without using pencil and paper. If a Realtor needs to put the information in writing for a client, they can return to their office, and prepare an informal appraisal or estimate of market value. This is why it is important to work with a local expert.
There has to be a practical way to quickly look at a property or several properties and be able to do a prompt calculation in your head. Realtors often need an expeditious way to evaluate a piece of property in their day to day business.
Realtors rely on capitalization rates and gross multipliers as a steady constant to arrive at value for residential income property and commercial property. The gross multiplier is arrived at by taking the monthly, or usually yearly, income a property produces and dividing the price by the rental income. This gives an economic characteristic of the property from its income. The cap rate is the process of converting the net income of a property into its equivalent capital value. The capitalization rate is defined as a rate of return, or percent, used to convert income into its value equivalent, a return on your dollar invested. Both of these methods are primarily used to establish value of income or rental property and commercial properties.
Sometimes the meaning or “weight given” to evaluations and estimations of property can vary depending on what the intended use is. Lenders can look at property from one perspective, courts another and we all know that buyers and sellers see the same property differently. With investment or rental properties using “cap rates” and “gross multipliers” can help make the evaluation process more uniformed, less subjective.
These rates and figures are not set in stone. As market conditions change, gross multipliers and cap rates change in their significance.
Always remember, the condition of the property and the location of the property play a huge impact on any evaluation. Local knowledge and experience of market conditions is critical.
This article was published in the San Francisco Examiner.
Articles are written by Eric Ruxton and Larry Aikins, owners of Terrace Realty, Inc. and Terrace Associates, Inc. in Redwood City. Terrace has been in business more than 55 years and in addition to being an independent Brokerage Company, also owns and operates rental properties.