Property is the biggest asset that today most of us hold. Knowing the estimate of this property comes in handy for various reasons such as taxes, selling the property, analyzing the investment, and managing the finances. But for most of us, it is important to only know the true value or asking price of the property.
What are Basic Valuation Methods?
As per the industry norms, the value of a property will be based upon the current market value and the future real estate growth of the area where the property is situated. Real estate is not consumer goods, the real value of it is realized only after a few years.
Hence, it becomes important to take the property value into consideration along with social trends, environmental conditions, and governmental norms. The factors are to be considered to ensure that they don’t influence any of the following value points:
- Utility, the ability to consider the future property owner’s requirements
- Transferability, convenience through which the ownership rights can be transferred in the future
- Demand, the ownership requirement and the financing abilities to achieve that
- Scarcity, limited supply of competing properties
Valuation Method: What is the difference between cost and price versus value?
The value will not always be equivalent to the cost. Cost is the actual expenses on material, labor, and other peripherals. Price is the exact amount someone pays for things they want. Cost and price will have an impact on the value, but they play no role in determining the value.
The sale price of a property could USD 300,000, but the value for the same property can be higher or lower than this amount. For instance, if the property owner finds the property comes without earthing, the house will be significantly valued lower.
Valuation Method: Market Value
Understanding the market value of a property is the job of the professionals— the appraisers. The appraiser will give the exact valuation of the property as per the current market standards.
The reports created by the appraisers will then be used by real estate investment companies (government and private), to take the necessary decision over that property.
The appraiser has only one goal, to give the most competitive property pricing considering the current and near-future market growth.
However, the market price is not similar to market value. For instance, if the seller is under pressure fearing foreclosure, then the property more often then not sells below market value.
Property Valuation Methods
Before the appraiser identifies the value of a property, they will ensure that they collect all the important methodical data. Data that comprises everything from the owners to the property’s standing in the town, city, state, and country. To analyze the property value, an appraiser will use five approaches.
Approach I: Sales Comparison
Commonly known as the market approach, this method always depends on the data acquired from the most recent sales for comparable properties. By finding the most recent buildings that were sold similar to your property and in the same vicinity, a buyer hopes to find the fair market price for the property into consideration. These comparable properties should have a legitimate comparison, and must have:
- Be similar in several aspects as your property
- Should be sold in similar market conditions as yours
- Should be sold in the past year in the recent competitive market
It is mandatory to consider at least four comparable by the appraiser. The comparable that has the most impact on the value of the property are features, size, and market location.
It is true that not every property will be alike, dissimilar features will be considered for making adjustments and a few other factors that may have some effect on the value, which includes:
- Condition and age of the building
- Sale date, if there are any economic changes that have occurred between the sale data and appraisal date
- Sale terms and conditions, for instance, the property was sold to relatives or if the owner was under threat
- Property location, given that similar property in the same vicinity, will have different pricing
- Property features (physical), which also includes the construction quality, area of the living space, property upgrades and more
Approach II: Cost Approach
The cost approach is simple, any real estate investor should never opt for buying a rental property for a higher price that is required to build a replica of the property. This approach is based on a common valuation method, the sales comparison method. The cost approach is highly effective when the appraised property is the kind that is not frequently sold has never generated income. For instance, government buildings, hospitals, schools, or churches.
Once the appraiser evaluated the property’s land value, it is clubbed with the construction cost of the building. There are multiple ways to identify building costs. One of the easiest ways is to find out the square foot cost and multiplying that with the comparable square footage. Apart from this, every real estate investor should consider depreciation costs as well.
Depreciation means any condition that may have negatively affected the property value, and always considers:
- Physical, if the property has deteriorated physically such as broken roof, paint job, and more
- Functional, design or physical features that no longer appeal to property owners
- Economic, it is when a property is located at an undesirable location
- Consider the land value as vacated land, which would have been available for its best use, perform this action using the sales comparison method because land cannot be depreciated
- Consider the site improvement and building construction cost
- Consider the depreciation amount of the property improvements which may result due to any of the depreciation factors
- Subtract the estimated cost of construction from the depreciation
- Achieve the property value by adding the estimated land value to the building depreciation cost
Approach III: Income Capitalization
Also known as the income approach, this third method is based on the net income that the property generates and the rate of return that the investor expects. Appraisals in this approach are fairly straightforward when the property in the discussion will be generating future income, and when the expenses towards this property are steady and predictable.
In the income capitalization approach, appraisers will often apply the direct capitalization approach to this as well:
- Predict the potential annual income
- Consider the rent and vacancy collection losses to identify the total gross income
- Add the capitalization rate towards the annual income of the property to get a realistic estimate towards the value of the property
- Subtract the annual expenses for operating for calculating the net annual operating income
Approach IV: Gross Income Multiplier
The GIM (Gross Income Multiplier) compares and measures the value of the property by considering the property price and then dividing the same by the total income.
For instance, if you have invested in a commercial property worth USD 300,000 and it is generating USD 80,000 total rent each year, the GIM would be calculated by dividing the property worth with the rent. This formula is usually used for identifying properties that are yielding low income as opposed to their actual market worth.
Rental data and recent sales from a minimum of three identical properties can be used for establishing accurate GIM.
Approach V: Per Door Value
This method is rarely used for single units, it always used for the valuation of an entire building. This method will help identify the total worth of the building based on the units it houses.
Concluding thoughts The dynamics of the real estate industry is changing, giving rise to ever-growing competition. Insurers, sellers, lenders, buyers, investors need to know the actual valuation for real estate.
By now we know that appraisals are performed only by professionals, any person who has been involved in a real transaction will get a basic understanding of the different valuation methods that are involved in real estate.