Don't Trust Your Realtor.
Common Valuation Mistakes
Ok ok... I don't really mean to not trust your Realtor or other advisors, unless they give you really bad advice, like the three mistakes outlined in this article. Many Realtors understand how to value real estate and can be a great asset (especially the ones that focus on real estate investors), but the unfortunate truth is that many investors and agents make these common mistakes:
- Add value to a property for a bedroom
- Incorrectly adjusting for square footage
- Compare non similar style homes with no adjustment
Add value to a property for a bedroom
This is by far the most common error that I see. In some cases a bedroom will add value but normally you cannot count on it. If a house has more bedrooms it is likely bigger and the large home is more valuable, but the bedroom itself is not adding the value, the square footage is. If two houses are the same size and one has an additional bedroom it is lacking something else OR has much smaller rooms, which will deter some buyers. It is basically a wash for valuation purposes. The one exception to this is if the house does not conform to the neighborhood. For example, if the entire neighborhood is two or three bedrooms and you have a one bedroom, it actually should add value to add a bedroom, even if you are keeping the house the same size. I would be very careful in these rare cases because it is hard to know how much value a bedroom will actually add. So when you are looking at your comps, look at the size and not the number of bedrooms. The real mistake I see people make is they add value for the additional sq footage and they add value for additional bedrooms which basically means they are adding value for the same sq footage twice.
This does not hold true for bathrooms. Bathrooms will almost always add value.
Incorrectly adjust for square footage
A less common, but more devastating error that I see is to use a price per square foot model to value a home. Many agents make this mistake. The error is to use an average price per square foot and multiply that number by the size of the house you are trying to value. It is not wise to use this method, especially if your house is on the small or large size for an area. Think about it. Is a 2,000 square foot house really worth twice as much as a 1,000 square foot house that might be next door? The area brings a certain range of values that all houses fall in and the lot values should be close to identical no matter what size house is on it. Using a price per sq foot model does not account for the lot.
It is true that you need to adjust for size, because larger homes carry more value, but it is easy to mess the adjustment up. The best way to do this is to dig into your comps and get an idea for the required adjustment. This can be very tricky because the value per square foot decreases as the homes get larger. It is a safe bet to never buy the largest or smallest house in an area, but if you do, use a very conservative adjustment for size. One rule of thumb that I like to use is 1/4th of the average price per square foot as the size adjustment. This will get you pretty close, so it is nice; but again is a rule of thumb and is not science.
Keep in mind that the adjustments that I mentioned are above ground adjustments. Basements do NOT carry the same value. In fact, it is normally worth less than half of the above ground square footage. For example, in a nice area an above ground adjustment might be $90.00 but basements in that area might only be worth an adjustment of $30.00 per finished sq foot. I never have understood this because if finished, it is usable/livable space and people love basements. I gave up trying to understand why the basement has such little value and have just accepted it. You don't need to understand why it is true as long as you know it is true and use that to help come up with an accurate value.
Compare non similar style homes with no adjustment
This one makes me laugh when I hear it. The biggie that I see here is comparing the ranch or rambler style home to a home with stairs, like a bi-level or 2-story. The house with no stairs is always more valuable. You need to think of yourself as the buyer and what a buyer would want. Another common example of this mistake is comparing older homes to newer homes. In fact, we just took a call today from a client that was comparing her home to a never been lived in house one neighborhood over. They were almost identical in size and were within a quarter of a mile to each other, but one is about 30 years old and one was just built. All she was looking at is the size and bed/bath count. The newer home is worth more, so it is best to not even use that comp; but if you need to use it, be sure to adjust for the age. Sometimes we will see weird comps used like this in an appraisal but they are almost always there to support an opinion of value and not to actually come up with the opinion of value.
My hope is that by understanding these common mistakes you will be able to come up with more accurate after repaired values (ARV), and be a better investor for it.
There is a lot more to valuing property than I can explain in an article like this. MnREIA was kind enough to allow me to come in and speak on their October meeting to dive into much more detail about how to look at your comps and how to use them to come up with your ARV.