There are three approaches to value real estate: (a) comparable sales approach, a relative valuation method, (b) income approach, a time value of money based method, which includes the (i) direct capitalization method and (ii) discounted cash flow method, and (c) cost approach, which values real estate at its replacement cost.
Just like any other asset, real estate value must correspond to its capacity to generate future cash flows. The easiest approach is to value a property is to base it on the value actually assigned to other properties in the market i.e. the comparable sales approach. However, because no two properties are the same and significant differences exist between properties, this approach is not appropriate for all properties and must be used with caution. A theoretically more sound approach is one in which we estimate the actual cash flow potential of the property and value the property at the present value of the future cash flows i.e. the income approach. When no comparable market transactions are available, and it is hard to forecast future cash flows correctly, the cost approach can be used which values a property at its replacement cost.
Comparable sales approach
The comparable sales approach is a relative valuation method. Just like we find out price multiples for different stocks i.e. price to earnings ratio (P/E ratio), price to book ratio (P/B ratio), etc., in the comparable sales approach, we identify past transactions of comparable properties and use them as benchmark to determine value for our property.
Comparable sales approach involves the following steps:
Income approach
The income approach is an absolute valuation method. There are two variants of the income approach: the simpler direct capitalization approach and the more advanced discounted cash flow method.
Direct capitalization method values a property as a perpetuity i.e. an infinite stream of cash flows. It is similar to the Gordon growth model (the dividend discount model).
Value of a property under the direct capitalization approach can be worked out using the following formula:
$$ text{V}=frac{text{NOI}}{text{c} - text{g}} $$
Where,
NOI is the annual net operating income, c is the cap rate, and g is the annual growth rate.
The discounted cash flow approach forecasts net operating income (NOI) for foreseeable future by individually forecasting the revenue and expense line items, finding a reversion value i.e. terminal value at the end of the initial foreseeable period and then discounting all the future cash flows using the required rate of return. The required rate of return is a discount rate which correctly captures the property’s risk.
Following is the formula for discounted cash flow approach:
$$ text{V}=frac{{text{NOI}} _ text{1}}{{(text{1}+text{r})}^text{1}}+frac{{text{NOI}} _ text{2}}{{(text{1}+text{r})}^text{2}}+text{..}+frac{{text{NOI}} _ text{n}}{{(text{1}+text{r})}^text{n}}+frac{text{RV}}{{(text{1}+text{r})}^text{n}} $$
Where
NOI1, NOI2 and NOIn are the net operating income in first, second and nth period, RV is the reversion value (terminal value) and r is the required rate of return.
RV can be estimated using either the multiple-approach or direct capitalization approach.
Cost approach
The cost approach values a property at its replacement cost i.e. the cost that will be incurred in reconstructing the property. The value of a property under this approach equals the market value of the land on which it is constructed plus the cost of construction of a similar property at current prices.
This approach has a major theoretical weakness because it determines value of a totally new property which may have lower repairs and maintenance costs as compared to an old property.
Example
You own a 50-unit residential 3-bed apartment complex in Toronto with total area of 50,000 square feet. Let’s call it Property Y.
Average occupancy rate is 90% and the average monthly rent is CAD 8,000 expected to grow by 7% each year for foreseeable future i.e. initial 5 years. 6% of the revenue is never collected. Monthly operating costs are 20% of the revenue in first year and are expected to grow in line with the Consumer Price Index (CPI), let’s say 3% per annum. Insurance costs are 3% of the capacity. Other revenue per year amounts to $500,000 which are expected to stay constant for next 5-years. Property taxes are 5% and income tax is 20%.
During last year, three apartment buildings were sold within one square kilometer area: Building A had a total covered area of 25,000 square feet building, had 30 units and was sold for $40 million; Building B had area of 70,000 square feet, 60 units and was valued at $70 million and Building C had area of 60,000 square feet, 42 apartment and was sold at $55 million.
The market value of the land is $30 million, and it took $20 million to construct the building 10 years ago. Assuming inflation over the last 10 years to be 2.5% on average.
During the last 3 years, comparable properties were valued based on a 10% capitalization rate. Assume in a net average growth in NOI is 5% for the purpose of direct capitalization method forever.
Work out a lower and upper bound for the property’s value based on the most popular real estate valuation methods. Required rate of return keeping in view the risk is 11%.
Comparable sales approach
The comparable sales approach is the simplest method even though it is impossible to find a perfectly comparable property. The following table shows how the comparable sales approach can be applied to the Property Y:
Direct capitalization method
For the purpose of direct capitalization method, we need to first work out the net operating income (NOI) in Year 1:
Given a cap rate of 10% determined as the average ratio of the NOI to property value of comparable properties and a growth rate of 5%, the value of the property under the direct capitalization approach works out to CAD 67.532 million:
$$ text{V}=frac{text{$3,376,600}}{text{10%}-text{5%}}=text{$67,532,000} $$
Discounted cash flow method
In order to apply the discounted cash flow approach, we need to work out future NOI by forecasting each line item in the NOI calculation, find out a terminal value and then discount those future cash flow to time 0 using the required rate of return.
The following table shows forecasted NOI:
The reversion value i.e. the terminal value is calculated using the direct capitalization method formula:
$$ text{V}=frac{{rm text{NOI}} _ text{5}times(text{1}+text{g})}{text{r}-text{g}}=frac{text{$4,428,889}times(text{1}+text{5%})}{text{11%}-text{5%}}=text{$77,505,550} $$
Cost approach
The value under the cost approach equals the market value of land plus the construction cost of the building in today’s dollars. The market value of land is $30 million, and the current value of the construction cost can be determined by adjusting the historical cost for inflation.
$$ text{V}=text{L}+text{C}=text{$30 million} +text{$20 million}times{(text{1}+text{2.5%})}^{text{10}}=text{$55.60 million} $$
by Obaidullah Jan, ACA, CFA and last modified on
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The formal process of valuation of real property is known as real estate appraisal. While an appraisal can be involved and complicated, three generally accepted methods are used to determine value. Which particular method is the most appropriate and accurate depends on the type of property being appraised and the purpose of the appraisal.
Sales Comparison Method
This method of valuation is the most well known, as it is used either exclusively or extensively for appraising residential real estate, especially for the purpose of securing a mortgage. It is also known as the market approach. The appraiser uses the sales prices of other homes in the area that are as similar as possible to the property being appraised. These other homes are referred to as 'comparables.' For example, if the subject property has four bedrooms and two bathrooms, the comparable should be the same and as closely located as possible to the subject property.
Cost Replacement Method
The question asked in this method is how much it costs to replace or duplicate the subject property, which comprises two major aspects. First, the value of the land of the property has to be determined. This is done using the market approach, by analyzing the sales prices of comparable plots of land. Next, the value of the property's structures is determined by calculating the building costs of the structures and then subtracting for physical and functional depreciation. The land value plus the net building value yields the cost replacement valuation figure. This method is most appropriate for properties that are unique or specialized in purpose.
Income Capitalization Method
This method is applied only when the subject property produces some sort of income, usually in the form of rental income. This method focuses on return on investment and that the value of the property is determined by how much income it can produce. The appraiser must calculate the total gross potential rental income and then deduct for vacancy times and expenses to figure the net income of the property. The appraiser then applies a capitalization rate to determine the value of the property. For example, if the net income is $100,000, and a 10 percent cap rate is used, the property is valued at $1 million.
Use and Reconciliation
A formal real estate appraisal should also investigate if the subject property is at its highest and best use. For example, a simple home on a piece of land legally usable for a shopping center is likely not highest and best use. After the different methods yield value figures, the appraiser has to reconcile them to reach a final estimate of value. A major factor in this reconciliation is the type of property and the purpose of the appraisal. A standard owner-occupied home being appraised for a mortgage would rely heavily on the sales comparable method figure. A standard apartment building would have much weight given to the income method.
References (3)About the Author
Kerry Zias has been a strategic business consultant and college instructor of business administration courses since 1990. He has taught courses and performed professional consulting work in the areas of marketing, management, business start-ups, entrepreneurship, real estate, sales psychology and performance, business communications, business law and political/governmental relations. Zias holds a Master of Business Administration in marketing from National University.
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Zias, Kerry. 'Valuation Methods for Real Estate Property.' Home Guides | SF Gate, http://homeguides.sfgate.com/valuation-methods-real-estate-property-47247.html. Accessed 02 July 2019.
Zias, Kerry. (n.d.). Valuation Methods for Real Estate Property. Home Guides | SF Gate. Retrieved from http://homeguides.sfgate.com/valuation-methods-real-estate-property-47247.html
Zias, Kerry. 'Valuation Methods for Real Estate Property' accessed July 02, 2019. http://homeguides.sfgate.com/valuation-methods-real-estate-property-47247.html
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Determine the value of financial accounts. To calculate the gross estate you need to add together the values of all the component parts. Start by determining the value of the financial accounts that are attributable to the estate. In some instances, the entire balance of a financial account may not be attributable to the estate. To decide what part of any financial account is attributable to the estate, follow these guidelines:
Estimating the value of real estate is necessary for a variety of endeavors, including financing, sales listing, investment analysis, property insurance and taxation. But for most people, determining the asking or purchase price of a piece of real property is the most useful application of real estate valuation. This article will provide an introduction to the basic concepts and methods of real estate valuation, particularly as it pertains to sales.
![]() Basic Valuation Concepts
Value
Technically speaking, a property's value is defined as the present worth of future benefits arising from the ownership of the property. Unlike many consumer goods that are quickly used, the benefits of real property are generally realized over a long period of time. Therefore, an estimate of a property's value must take into consideration economic and social trends, as well as governmental controls or regulations and environmental conditions that may influence the four elements of value:
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Value Versus Cost and Price
Value is not necessarily equal to cost or price. Cost refers to actual expenditures – on materials, for example, or labor. Price, on the other hand, is the amount that someone pays for something. While cost and price can affect value, they do not determine value. The sales price of a house might be $150,000, but the value could be significantly higher or lower. For instance, if a new owner finds a serious flaw in the house, such as a faulty foundation, the value of the house could be lower than the price.
Market Value
Methods For Valuing Real Estate Companies
An appraisal is an opinion or estimate regarding the value of a particular property as of a specific date. Appraisal reports are used by businesses, government agencies, individuals, investors and mortgage companies when making decisions regarding real estate transactions. The goal of an appraisal is to determine a property's market value – the most probable price that the property will bring in a competitive and open market.
Market price, the price at which a property actually sells, may not always represent the market value. For example, if a seller is under duress because of the threat of foreclosure, or if a private sale is held, the property may sell below its market value.
Appraisal Methods
An accurate appraisal depends on the methodical collection of data. Specific data, covering details regarding the particular property, and general data, pertaining to the nation, region, city and neighborhood wherein the property is located, are collected and analyzed to arrive at a value. Appraisals use three basic approaches to determine a property's value.
Method 1: Sales Comparison Approach
Blueprint reading for welders and fitters answer key printable. The sales comparison approach is commonly used in valuing single-family homes and land. Sometimes called the market data approach, it is an estimate of value derived by comparing a property with recently sold properties with similar characteristics. These similar properties are referred to as comparables, and in order to provide a valid comparison, each must:
At least three or four comparables should be used in the appraisal process. The most important factors to consider when selecting comparables are the size, comparable features and – perhaps most of all – location, which can have a tremendous effect on a property's market value.
Comparables' Qualities
Since no two properties are exactly alike, adjustments to the comparables' sales prices will be made to account for dissimilar features and other factors that would affect value, including:
The market value estimate of the subject property will fall within the range formed by the adjusted sales prices of the comparables. Since some of the adjustments made to the sales prices of the comparables will be more subjective than others, weighted consideration is typically given to those comparables that have the least amount of adjustment.
Method 2: Cost Approach
The cost approach can be used to estimate the value of properties that have been improved by one or more buildings. This method involves separate estimates of value for the building(s) and the land, taking into consideration depreciation. The estimates are added together to calculate the value of the entire improved property. The cost approach makes the assumption that a reasonable buyer would not pay more for an existing improved property than the price to buy a comparable lot and construct a comparable building. This approach is useful when the property being appraised is a type that is not frequently sold and does not generate income. Examples include schools, churches, hospitals and government buildings.
Building costs can be estimated in several ways, including the square-foot method where the cost per square foot of a recently built comparable is multiplied by the number of square feet in the subject building; the unit-in-place method, where costs are estimated based on the construction cost per unit of measure of the individual building components, including labor and materials; and the quantity-survey method, which estimates the quantities of raw materials that will be needed to replace the subject building, along with the current price of the materials and associated installation costs.
Depreciation Ck2 duchies.
For appraisal purposes, depreciation refers to any condition that negatively affects the value of an improvement to real property, and takes into consideration:
Methodology
Method 3: Income Capitalization Approach
Often called simply the income approach, this method is based on the relationship between the rate of return an investor requires and the net income that a property produces. It is used to estimate the value of income-producing properties such as apartment complexes, office buildings and shopping centers. Appraisals using the income capitalization approach can be fairly straightforward when the subject property can be expected to generate future income, and when its expenses are predictable and steady.
Direct Capitalization
Appraisers will perform the following steps when using the direct capitalization approach:
Gross Income Multipliers
The gross income multiplier (GIM) method can be used to appraise other properties that are typically not purchased as income properties but that could be rented, such as one- and two-family homes. The GRM method relates the sales price of a property to its expected rental income. For residential properties, the gross monthly income is typically used; for commercial and industrial properties, the gross annual income would be used. The gross income multiplier method can be calculated as follows:
Sales Price ÷ Rental Income = Gross Income Multiplier
Methods For Valuing Real Estate For Probate
Recent sales and rental data from at least three similar properties can be used to establish an accurate GIM. The GIM can then be applied to the estimated fair market rental of the subject property to determine its market value, which can be calculated as follows:
Rental Income x GIM = Estimated Market Value
The Bottom Line
Accurate real estate valuation is important to mortgage lenders, investors, insurers and buyers and sellers of real property. While appraisals are generally performed by skilled professionals, anyone involved in a real transaction can benefit from gaining a basic understanding of the different methods of real estate valuation.
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