When buying a property, the valuation data (how much it is really worth) and the price (how much it costs to buy it) is not always the same. This is where we comes in.
Property valuation, also known as real estate appraisal, is the process that determines the fair market value of a real estate property, the price at which a seller willingly sells their property and a buyer will willingly purchase it. It ensures that both partie`s have all the relevant information and neither is forced to buy or sell. This also forms the basis for the property’s taxation, insurance, and mortgage loans.
Property valuation data helps the real estate buyer and seller agree at a certain price which might be either less or more than what the real estate property is worth.
Four Foundation Pillars of Property Valuation
Property valuation lies upon four foundational pillars:
- Demand – The magnitude of interest and buying power in the market for purchasing the property.
- Utility – The ability of the real estate to satisfy the use or need of prospective purchasers.
- Scarcity – Recognizes that there is a limited supply of real estate.
- Transferability – This refers to the ease at which a parcel of real estate can legally be transferred to a new owner.
Three Main Property Valuation Methods
The following are the main property valuation methods performed today:
Sales Comparison Approach
The Sales Comparison Approach is an estimate of the real estate property’s value by comparing recently sold properties with similar characteristics. In order to get a realistic comparison, three requirements must be met:
- The two properties must be as similar as possible.
- The sale date should be as recent as possible.
- The two properties must be as close as possible.
This approach is a generic method to set a baseline for evaluation but it’s not a perfect approach for evaluation since each property is unique and that makes it difficult to compare to others.
Adjustments are needed to account for differences between the two estates. The appraisers must know the differences between the comparable properties and how to value these differences in order to make proper adjustments.
The sales comparison approach is a great method for properties that have distinctive features that can’t be found in other properties.
The sales comparison approach involves the following steps:
- Identifying market transactions in the recent past of comparable properties. The transactions must be similar to the property’s size, location, nature (residential or commercial), tenant size and lease duration.
- Finding price multiple for the properties based on some features of the property which derives the property’s value.
- The multiples derived from comparable transactions are then multiplied with the same feature of the property to get a value estimate.
Cost Approach
The Cost Approach considers the value of a property as the cost of the land plus the cost of replacing the property minus the physical and functional depreciation. It uses similar methods to the sales comparison approach except it isn’t used in the valuation of residential properties. The cost approach is the method commonly used for properties that are not easily sold like government buildings, schools, and hospitals.
The cost approach involves the following steps:
- The land cost is estimated by studying recent sales of land close to the subject property.
- Once the land value is estimated, it is summed with the estimated building costs of the real estate property. The building cost can be estimated in a lot of ways but the most common is to find out the cost of a square foot and multiply it by the total square footage of the comparables.
- After the building costs are found, the depreciation costs are subtracted. There are three types of deprecation costs; physical deterioration, functional obsolescence, and economic obsolescence.
- Physical deterioration – This pertains to the deterioration within the property that can be repaired.
- Functional obsolescence – This refers to aspects of the property that are not desirable in the present time.
- Economic obsolescence – This is a form of depreciation caused by factors that are not on the property. An example is the location is next to an airport or the neighbourhood experiencing a rise in crime.
Income Capitalization Approach
The Income Capitalization Approach is the method used for income-generating properties like apartment buildings, commercial real estate, office buildings, and shopping centers. This approach considers the return on investment and the income of a property.
This approach subdivides into two valuation methods; the direct capitalization method and the gross income multiplier method.
Direct Capitalization Method
The direct capitalization method focuses on a property’s income.
It takes into consideration vacancy and rent collection losses to determine the effective gross income. From there, the net operating income is calculated by subtracting expenses. Then, the property’s value is estimated using the rate of return, or capitalization rate. Finally, the capitalization rate is applied to the property’s annual net operating income to form an estimate of the property’s value.
Gross Income Multipliers
The Gross Income Multiplier (GIM) method is used for properties that are not initially purchased as income properties but end up being used as such as rental family homes. The gross income multiplier method can be calculated as follows:
Sales Price ÷ Rental Income = Gross Income Multiplier
Note: For residential properties, the gross monthly income should be used. For commercial and industrial properties, the gross annual income should be used.
To establish a more accurate GIM, recent sales, valuation data and rental data from at least three similar properties can be used. The GIM can then be applied to the estimated fair market rental of the property to determine its market value.
It can be calculated using the following formula:
Rental Income x GIM = Estimated Market Value
Conclusion
Whether you are a property buyer, a property seller, a mortgage lender, and a real estate investor, it is important for you to know and understand property valuation data. Yes, appraisals are handled by professionals but anyone involved in the transaction can benefit from knowing the basics of property valuation.