I’m in Hawaii right now… it’s winter but still a happy 28℃
And I was at a fancy ice cream shop picking a flavor when I noticed that the building was for sale.
And so was the building opposite, over the road.
It got me thinking about you…
Here’s the thing…the building the ice cream shop was in is a beautiful old building with some lovely features.
The one over the road (I don’t know what they were thinking!) was a pretty ugly glass and concrete box.
On the face of it I know which one I’d like to own… but this is the question…
How do you know which one is the best investment?
How do you know which one is worth investing in?
Let’s dive in…
You need to take an analytical approach here and not just look at the price the valuer or agent gives you.
Because if you don’t analyse the pros and cons, you can’t maximise your returns. Even if the property is promising, you risk overpaying for it. And why waste money on a subpar property when you can use it to grow your wealth instead?
The good news is that there's a clear framework for valuing your desired property the right way. It consists of three methods. You can pick and choose, but many investors use all three in conjunction.
Let's dig deeper into these methods.
- Income Method
The income method is the first and most useful. In many cases, it can tell you everything you need to know about whether you should invest.
The way it works is quite simple.
The first thing you must do is find out the net income of your property. You can either get this figure from the seller or calculate it by subtracting the outgoings from the gross income.
Once you have the right number, divide it by the purchase price to get the property's capitalization rate (also known as the cap rate).
For example, let's say that you're looking at a $400,000 property with a net income of $30,000. This would mean that your cap rate is 7.5%.
However, you must compare this number to recently sold properties and their cap rates. This will show you if you're paying a fair price for the property.
It’s as simple as that. If the projected return is 7.5% and recent sales achieved 9%, this would be a clear sign that the property is too expensive.
If that’s the case, you should either negotiate for a better price or move on.
To sum up, there are three steps to the income method:
- Calculate the net income
- Calculate the cap rate
- Compare to the area’s recent cap rates
As mentioned, this should be enough to show if a property is worth it. But if it's not conclusive, there are two other methods to use.
- Comparable Sales Method
The idea behind the comparable sales method is that no investor will pay a high price for a property when similar ones are going for less.
The method protects you from overly high property prices.
It’s also as straightforward as they come. You’d just research similar properties as a comparison. If the price sticks out in any way, negotiate or forget about it.
- Replacement Costs Method
This is more of a backup method than one that you should always use. The idea behind it is that the value of a property should be below today's build price.
Here’s an example: I looked at a property valued at $1.3 million, but the replacement costs were $2 million, as it was an ornate building.
You must know the replacement costs so you can know how much to insure your property for. Otherwise, you might have a big problem if something catastrophic happens to the building.
To find the replacement costs of your building, use the following formula:
Replacements costs = build costs + land value – depreciation
As you can see, it's quite easy to figure out if a property you want to buy is worth the selling price. The hard part is getting the necessary information.
Using these methods shouldn’t prevent you from being thorough with your due diligence. They’ll help you decide whether to go ahead with a property or not. Once you make that decision, you still need to do your research.
If you need any help, sign up for my webinar to learn more.