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Accurately valuing an investment property in South Florida using CAPM

System - Friday, August 6, 2021

The current real estate market conditions in South Florida are making the ownership of local rental properties a very intriguing prospect. When trying to decide whether or not you should pull the trigger on the purchase of a specific property, it’s of extreme importance to ensure that an accurate valuation of the property has been performed. This helps you to decide if it is a potentially profitable investment opportunity. In our last blog, we detailed some different ways that can be used to determine proper valuation for a property. We discussed the following approaches:

  • The income approach
  • The sales comparison approach
  • Gross rent multiplier

Please feel free to visit our last blog to get additional details on these previously discussed approaches. In this blog, we are going to discuss additional methods that can be used to evaluate potential property purchases.

The Capital Asset Pricing Model

This approach is more comprehensive than the ones we discussed in the last blog post. This method is based on the estimation of the opportunity cost and the inherent risk as they pertain to an asset. CAPM establishes multiple bases for comparison’s sake, such as the rate of return on US Treasury Bonds, or the rate of return on Real Estate Investment Trusts (REITs). These investment vehicles have essentially zero risks. After the basis has been calculated for these essentially worry-free types of investments, the Capital Asset Pricing Model estimates the potential return on investment (ROI) for the property under consideration. When the estimated ROI is less than the return associated with one of the risk-free investments, it gives a strong “don’t buy” indicator because it wouldn’t be a smart decision to make the purchase of an asset that contains built-in risk yet has a lower expected return.

The inherent risks of owning real property are different from property to property. Location is one important variable that warrants consideration. If the property happens to reside in an area laden with crime, the amount of rent an investor can expect to receive from the property will most likely be much lower than the amount that would be collectible in a safer area of the community. Additional capital may need to be spent on safety precautions in these more perilous locations. Extra locks, fences, and even potentially bars on windows may be a wise investment in order to protect your asset.

The age of the property under consideration is also a factor to take into account. The older a building is, the more maintenance you can expect it to need. After considering these factors, the CAPM helps you decide what rate of return an investor should expect for putting their hard-earned money “at-risk”. The return should always be higher than the rate of return afforded by the risk-free options that are available. Otherwise, the property is probably not the best investment decision.

The Cost Approach

The cost approach is predicated on the belief that a piece of property is only worth what it can be reasonably and legally used for. This method calculates the valuation by adding the depreciated value of any improvements made to the property with the value of the raw land it sits on. This method is almost always used when assigning a valuation to vacant lots or unimproved pieces of land.

Zoning is another important factor to take into account when it comes to the cost approach. If the parcel of land under consideration is not currently zoned for the purpose that the investor intends the land to be used for, there will be a significant cost associated with getting the zoning modified. If a specific parcel of land is zoned for single-family homes, the zoning would need to be reassigned to high-density housing in order to build a condominium complex on that piece of land.

We have discussed various ways to perform valuations on different types of properties. The focus has been primarily on the evaluation of properties for investment purposes, but the core principles also apply to the acquisition of property for personal use. Most successful investors will use a combination of these approaches. Some will use all of the methods that we have discussed to help them make a decision about a specific property. Once some of these methods have been applied, you can determine how good the potential investment actually is from a financial standpoint. If the investment is found in a positive light, the next logical step would be to begin the process of securing the best financing. We will go into the financing process in an upcoming blog.

As always, Sunrise property management companies can be a tremendous resource for any investor. Please don’t hesitate to contact PMI Key Partner with any rental property questions.