You don’t make your money when you sell a home, you make it when you buy one. This little axiom is even more true with buying foreclosures, since the buyers tend to be investors.
Comparable sales are very important when establishing a pricing baseline for buying a foreclosure. So is replacement value. But an income approach is extremely important, and it often isn’t used enough.
With an income approach, the buyer determines how much the house will rent for, not just immediately, but out into the future. Next, she or he applies a capitalization rate (cap rate) to the net rental amount. A cap rate is the income divided by the value of the property. Warning: Cap rates assume an all-cash purchase.
So, one might ask, how can you apply a cap rate to projected income to get the value? Don’t you ave to know the value to determine the cap rate? Yes, in theory. But given cap rates tend to be generally accepted in certain areas. As a general statement, the higher the cap rate, the theory goes, the less risk the investment. And if you know any two of the three values of the formula C = I/V, where C is the cap rate, I the income and V the value, you can determine the one you don’t know.
What’s the cap rate for a house? It would depend on the neighborhood and the overall rental activity, but my guess is that they’re low. Somewhere in Portland Metro, a three-bedroom, 1,500 square-foot home might rent for $1,500 per month, or $18,000 annually, or a net operating income of $14,400 (adjusting for vacancy and operating expenses). If the cap rate were 6%–a fair theoretical starting point–the house would be worth $240,000.
Which is about the median price of a home in Portland Metro. So we’re sort of in there for a starting point.
The problem with cap rates is that there’s “the” cap rate and there’s “your” cap rate. The home you want may need a new roof, or you may be leveraging it and the interest costs are a factor. Or whatever. If you’re going to use a cap rate, you’ll need to modify it with your unique factors.
And if you come up with a house value and average it with comparable sales and replacement value, you’ll have a good working number when making an offer or bidding at auction.
