You make your biggest profit on a property when you buy it. In other words, if you structure a good deal at the front end, you are likely to sell at a good profit. This means that the price you pay for any property, and the terms on which you buy that property, will probably determine how successful you are in selling the home for a profit down the line.

Of course, you may get lucky. You may enjoy added appreciation for other reasons, but you should consider that just icing on the cake. Focus on structuring a good deal from the beginning, and chances are that you will be the richer for it later. If you don't feel comfortable with the price going in, don't buy the property. Go find a deal that you are comfortable with.

There are some fundamentals that determine whether or not a proposed transaction is a good deal. Simply stated, there are three approaches to determining the value of a property at any point in time, and you must understand and be able to determine these three different kinds of "values": 
(1) cost (2) market and (3) income 

After discussing these three traditional approaches to determining value, we will also explain our own approach, which we call enhanced value. This is the value you bring to a given transaction because of your own knowledge. It's the intangible "secret sauce"¡ª the wisdom you bring to the table about what can be done to the property to make it worth more. It is this kind of knowledge, we argue, that leads to true and lasting success in real estate.

THE COST APPROACH

The cost approach to value is based on what it would cost someone to duplicate the property in question, if that person were starting from scratch. Simply stated, you first determine the total square footage of the property¡ªcall it a house, for the sake of this example. Then you multiply that number by the square-footage cost for new homes in the area, also taking into account any sorts of special improvements that might add value to the property. Then deduct for depreciation: how much does wear and tear on the property detract from its value, compared to a brand-new version of the same property? Add in the value of the land in an unimproved state, and you'll have an approximation of the "cost value" of the property.

THE MARKET APPROACH

The market approach is the one most commonly used to appraise residential real estate. It is also called the "comparable" approach, and it is used by most Realtors, using a tool called the Multiple Listing Service, or MLS.

Simply put, the Realtor uses the MLS database to generate a list of homes that have sold in your area over the past six months, and you compare your proposed purchase to the properties on the list. Again, you would use specifics to adjust the value of your target property up or down. If your target property has more square footage, you could award it a higher value than the other homes you are comparing it to. Additions or deductions could also be made for other subjective factors, such as location relative to amenities or condition of the property, While the comparable approach requires some subjective determination on your part, it is easy to pick up once you start viewing the properties.

THE INCOME APPROACH

The income approach is the most fact-based appraisal approach because it is based simply on the numbers. Start with gross income; deduct for vacancies, debt service, and expenses; and you get the net income for the property. Once you find the net income, you compare it to the return you are willing to accept and "back your way into" the purchase price you can pay.

While the income approach is excellent for larger properties, it is difficult to use with many residential properties because prices have gone up faster than rental income. You may find that after you take out all of your expenses and debt service, you have a negative cash flow. In that case, no matter what multiplier you use, the property won't have a value with the income approach. Unfortunately, you won't get many sellers interested in selling you their property at a negative price, either.

If you buy properties with negative cash flow, you will wind up using either the cost or the market approach to justify your price. You will have to give extra value to your estimates regarding appreciation of the property, and of course that gets very unpredictable and speculative at times.

From experience, we can tell you that negative cash flow payments wear on you, as each and every month you write a check out of your income from other sources. It isn't fun, and it's one of the two major things that people don't like about real estate investing (the other is property management}. The upshot is, either you learn to live with the reality of writing those checks every month, or you structure your transactions to avoid negative cash flow. In later chapters we will discuss ways to do this, but the easiest is to add more cash up front and take on less debt service. If you don't have the cash yourself, then you have to come up with an investor who can help you solve the problem.

So there you have it: the cost, market, and income approaches to appraising the value of a property. In many cases, a skilled appraiser takes the results of all three approaches and puts them together, assigning the highest weight to the approach she considers most accurate for the property. It takes years of training and experience to get this right, but there's no reason why you can't get comfortable with and begin to use all three of these appraisal tools.

THE ENHANCED VALUE APPROACH

"Enhanced value" is our fourth approach to an appraisal. 

It is the true opportunity. It is the distinctive viewpoint that you, and only you, can bring to the transaction¡ªthe viewpoint that "sees" beyond the normal approaches to value and renders them almost irrelevant.

Donald Trump has it. It was the enhanced value approach that Trump used when he took the thirteenth hole of the Trump National Golf Club in Westchester County, New York, and spent $7 million creating an artificial waterfall on it¡ªthereby making it a featured and talked-about attraction, known by golfers worldwide. That hole, with its endlessly talked-about water feature, is one of the most photographed spots in golf. It makes people want to play at the club, and buy memberships.

Enhanced value is what you will work to envision, and create, in your real estate career. Maybe your vision won't embrace $7 million waterfalls. Maybe it will be limited to the ability to envision what a tumbledown shack will look like after your labor has transformed it. The scale and scope of your vision don't really matter much; what matters is your ability, developed over time, to see what could be there when you've finished enhancing the value of a given property. The longer you are involved in real estate, the better you will get at this, and the more exciting and financially rewarding the business will become for you.

 

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