Real estate property valuation is important to property sellers, property buyers, and real estate investors in order to determine the asking or purchase price of a real estate property. In this blog, you will learn about the basic concepts and methods of real estate property valuation that can help you make good investment decisions.
Property valuation, or real estate appraisal, is the process which determines the economic value of a real estate property. The process is not as easy as it sounds because unlike other transactions, such as stocks and shares, real estate transactions do not occur frequently and are unique in their nature. Therefore, the process of developing an opinion about the value of the real estate property is required.
Related: What Are the Main Property Valuation Methods?
In addition to establishing the selling price or value of a real estate property, property valuation forms the basis for mortgage loans, real estate property taxation, property insurance, and investment property analysis.
Value vs. Price
Property valuation seeks to determine the fair market value of a real estate property, which is the price at which a property owner is willing to sell his/her property and a property buyer is willing to purchase it. The fair market value assumes that parties know all the relevant information about the real estate investment and neither of them is forced to sell or buy. However, there can be differences between a property’s value (how much it is really worth) and its price (how much it costs to buy it). Therefore, the price paid to buy a real estate property might not always be the same as its market value.
The difference between a real estate property’s market value and price can be as a result of a special relationship between the property buyer and the property seller where one party has control over the other and can influence his/her decision making. For example, a real estate property can be sold for less than its market value because the seller is distressed and needs to get rid of the investment right away. Potential real estate investors who know this take advantage of the situation and buy the property for less than its market value.
In other cases, two parties can make a deal where several real estate properties are traded together, and in this case the price paid for each property does not correspond to that real estate property’s market value. Moreover, some property buyers are willing to pay a premium price, more than the market price, if their own property valuation results in a higher value, called investment value. An example of this is when an owner of a neighboring property knows that by combining his/her own real estate property to the subject property, he/she can obtain economies of scale and have a higher investment value.
The most common reason that makes the fair market value different from the price is the lack property valuation, or real estate appraisal. Property buyers and sellers who are uniformed about the market value agree on a contract at a certain price which might be either more or less than what the real estate property is actually worth. Therefore, property valuation is essential when buying an investment property.
The Four Foundation Pillars of Property Valuation
A real estate property value can be defined as the present worth of the future cash flows arising from the ownership of the property (rent). The benefits of a property are – unlike other goods that are quickly used – realized over a longer period of time. Therefore, property valuation must take into consideration economic and social factors that may influence the four main elements of value:
- Demand: It is the magnitude of interest or desire to buy and own a real estate property in the market.
- Utility: It is s the ability of a real estate property to satisfy the desires and needs of prospective purchasers.
- Scarcity: It is the finite or limited supply of real estate properties.
- Transferability: It is the ease with which rights of a property can be transferred to new owners.
Property Valuation Methods
Real estate appraisal uses three main methods to determine the value of the property.
Related: How to Value an Investment Property
Sales Comparison Approach
The sales comparison approach (SCA) is an estimate of the real estate property’s value by comparing recently sold properties with similar characteristics. Three requirements must be met for a realistic comparison:
- Comparable properties (real estate comps) should be as similar as possible to the subject property.
- The sale date should be as recent as possible. Older selling dates are not accurate for the current market.
- Comparable properties should be as close as possible to the subject property (location).
The sales comparison approach is a generic method to set a baseline for evaluation and not a perfect tool for evaluation. After all, each property has its own uniqueness that makes it difficult to compare to other properties. As a future real estate investor, using this method would give you a good estimate of the value of the property in question, especially if that property has distinctive features that cannot be found in other properties.
Cost Approach
The cost approach is a property valuation method that estimates the price of a real estate property by adding the cost of land as if vacant, plus cost of construction of a similar building, less depreciation. Estimating the cost of land can be difficult, especially if comparable vacant land is unavailable, which makes the valuation process less accurate.
Depreciation refers to any condition that decreases the value of a real estate property such as physical deterioration of the property, functional obsolescence, and other economic factors external to the property.
The cost approach method is used to valuate special-use properties that are usually not constructed to be sold such as schools, libraries, and other special purpose buildings.
Income Capitalization Approach
The income capitalization approach is a property valuation method used to valuate income-producing properties. To calculate property value, you need to divide the net operating income (NOI) by the cap rate, which can be obtained from comparable properties (real estate comps).
Valuating a real estate property using the income capitalization method can be easy and quick. Nevertheless, a large drawback of this method is determining the cap rate itself. Comparable properties must share the same location, features, and quality of building for their cap rate to be reliable.
Example on how to value a property using the cap rate:
Property Value = Net Operating Income/Cap Rate
Net Operating Income = Annual Rental Income – Operating Expenses
1- Determine the net operating income, or net rental income after expenses. Assume $40,000.
2- Determine the cap rate from comparable sold properties. Assume 11%.
3- Divide the net operating income by the cap rate.
$40,000 /0.11 = $363,636
Related: How Is Cap Rate Used for Evaluating a Real Estate Investment?
The Bottom Line
Accurate real estate property valuation is important to property buyers, property sellers, mortgage lenders, and real estate investors in general. Although real estate appraisals are performed by skilled professionals, real estate investors should be familiar with the basic concepts and methods of property valuation.
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