Investment property appraisal presents unique challenges, especially two to four-unit properties. We’re addressing common misconceptions as well as providing insight into important factors to consider when appraising investment properties.
Why invest in 2–4-unit properties?
Residential characteristics considered in single-family properties do not always apply to 2–4-unit properties. For example, unless the subject’s lot is big enough and zoning will allow for more units to be built, the typical investor seeking a 2–4-unit property would not likely pay more for an extra-large lot.
In fact, an extra-large lot may be seen by investors as a negative because of the additional costs involved in maintaining it. There are other factors that are normally adjusted for in single-unit appraisals which may be of little or no consideration in appraisals of 2–4-unit properties, unless those factors impact the amount of rent a tenant would be willing to pay, or the investor’s bottom line.
How to begin an investment property appraisal
Research for an investment property appraisal should begin with:
- Establishing a Gross Rent Multiplier (GRM) very carefully
- Establishing the subject property’s “market rent” even more carefully
- Finding out what the major factors are that appeal to prospective tenants in the market area. For example, an area dominated by 2-4 unit properties where all three-bedroom units rent for about the same amount regardless of the size of the unit
- Confirming zoning and code compliance, and making sure that the subject can be rebuilt if destroyed
- Accessing all the units to make sure they are in rentable condition and meet market expectations for the rents utilized in the appraisal
- Verifying the existence of leases as well as verifying the actual rents is recommended, when possible
- Considering realistic vacancy rates in the subject’s market area.
Vacancy rates require special consideration and are too often not given the scrutiny warranted. In performing reviews, I’ve typically seen a 5 percent vacancy rate estimate on investment properties.
Most rentals begin on the first of the month. When a tenant moves out there is a period of cleaning and repairing the unit, followed by a marketing period before the unit is occupied again. So, unless it is an extremely high demand market, most cases I’ve personally observed result in at least one month that the unit is vacant. That’s one-twelfth of the year or an 8.3 percent vacancy rate. Net income can be notably affected by vacancy rates of 8.3 percent versus 5 percent.
For example, using a potential gross income (PGI) of $100,000, a 5 percent deduction for vacancy would result in a loss of $5,000 or $95,000 in income. A more realistic 8.3 percent deduction for vacancy would be $8,300 less, resulting in $91,700 in income.
Personal observations in investment property appraisal
Personally, after owning a number of 2–4-unit properties and managing several for other owners over the years, I can attest that it’s all about net income. One could argue that a calculation of net operating income (NOI) would be warranted. If the investment makes little profit, or even loses money, who wants it? After discussing this in my live 2-4-unit appraisal courses and showing the class a sample PGI to NOI calculation form, virtually every student wanted a copy.
Often, there aren’t enough sales of truly compatible rental properties for statistically reliable calculations for sales comparison approach adjustments to the comparables for their differences with the subject property. Unless rents are impacted, these factors seldom have an impact on the price an investor will pay for a 2–4-unit property.
What does the typical investor for this type of property look for when purchasing? When I was a real estate broker, I never heard anyone say, “I want to look at 2-4-unit properties that are between 3,000 and 4,000 square feet.” The focus was always about income and expenses, and the bottom line.
In some circumstances, the cost approach can be particularly effective when appropriately zoned vacant land is available nearby. In other cases, the typical investor may not be considering building new, thus developing the cost approach might not reflect the market’s considerations. Often, market area boundaries must be expanded miles beyond traditional neighborhoods to find sales of truly compatible properties. In most cases, the investor cares about the bottom-line dollars, and the location is often of little or no importance.
Importance of proper training
It is often the case that new appraisers enter the profession without thorough training on appraising 2–4-unit properties. Unfortunately, some appraisers become form-fillers, letting the form guide the appraisal process rather than performing the appraisal and only using the form to communicate their results.
Take the next step with CE courses
If you’d like to learn more about investment property appraisals and other relevant topics, McKissock Learning has appraisal CE courses designed to build your skillset while meeting state requirements.
For the best value in continuing education, check out our Unlimited CE Membership. With full access to our entire course catalog, Learning Library, and monthly webinar series, you’ll be able to stay up-to-date on the latest news, build new skills, and grow your business!
Written by Steven W. Vehmeier, Appraisal Educator Emeritus. Steve retired from his appraisal and appraisal education practices after a long career specializing in writing and teaching pre-license and continuing education courses, including twenty-two years doing so for McKissock. He continues to write articles and blogs to share his knowledge and experience.
