Real estate valuation or appraisal helps in developing the market value of a property. Since each property, be it residential or commercial is unique, it is ideal to use an approach that suits the situation best, opines astro strategist Hirav Shah. Hirav Shah has been associated with his father’s realty business for quite some time and hence understands the sector in and out. He feels real estate valuation must be understood by all involved in real estate business
Real estate appraisal or valuation of property or land valuation as per Wikipedia is the process of developing an opinion of value of real property, which is usually the market value. As each property is unique, real estate transactions require appraisals as they occur frequently. Here, it is important to note that location also plays a key role in valuation.
Since location of the property does not change, upgrades to home and improvements change its value. Lot size, floor plan, amenities and other features are considered alongside the general demand and supply in a particular region to assess a property’s value. Several methods are used to appraise the value of individual properties.
Appraisal reports are important in the sense that they form the basis for financing, sales listing, investment analysis, property insurance, mortgage loans, taxation and so on. The reports also help in establishing a sale price of a property, which is one of the most useful applications of real estate valuation.
Appraisers are often referred to as property valuers or land valuers, while in British English, they are called valuation surveyors. Apart from formal education, which could be anything from finance to construction technology, most countries in the world require the appraisers to have a license.
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Real estate financial analysis is based on
To put it candidly, a property’s value is defined as the present worth of future benefits that a property owner can enjoy. The true potential of real property is realised over a longer period of time, unlike other consumer goods. Therefore, financial analysis of real property transactions takes into consideration the economic and social trends, apart from governmental regulations, controls and environmental conditions, all of which could affect the four elements of value.
- Demand: the desire or need to own a property based on one’s financial situation to satisfy that desire.
- Utility: this is the potential of a property to satisfy future owners’ desires and needs
- Scarcity: limited supply of competing properties
- Transferability: the ease with which the ownership rights can be transferred.
It has to be remembered here that the value of a property is not equal to cost or price. Cost means actual expenditure on labour, etc. Price is the amount one pays someone for something. So, while cost and price do affect value, they do not determine the value of a property. Let’s consider an example: If a villa’s sale price is around Rs 3 crore, the value could be higher or lower. If the new owner finds faults in the basic structure of the building, then the value can be much lower than the price.
Here, it is important to understand the term market value:
A real estate appraisal is an estimate of the value of a particular property as of a specific date. Businesses, government agencies, individuals, investors, mortgage companies use appraisal reports while making decisions regarding realty transactions. The universal goal of an appraisal is to determine a property’s market value, which in other words means the probable price that a property will bring in a competitive or open market.
Similarly, market price is the price at which the property gets sold out. However, this may not be the actual market value in most cases. For example, if a seller is under pressure due to the threat of foreclosure, then the property gets sold at a price way below the market value.
Understanding this basic difference will help you to understand how to analyse the real estate market.
Property valuation methods or appraisal methods
For an accurate appraisal, data is of primary importance. Procuring specific data covering details of property, where the property is located and other general data is vital. The same is analysed to arrive at a value. There are three basic approaches to determine a property’s value:
1) Sales comparison approach
The sales comparison approach is used for single-family homes and land. It is also referred to as a market data approach and it is an estimate of value derived by comparing a property with recently sold properties with similar characteristics. Such similar properties are called comparables and each of them must be – similar to the property up for sale, should have been sold in the past one year in an open, competitive market and should have been sold under typical market conditions.
At least three or four comparables must be used during appraisal. Size, comparable features, location have a strong impact on a property’s market value. However, since no two properties will be similar, the appraisal will consider features that are dissimilar that could affect value and also features that could add value.
These include
a) Age and condition of the building
b) Date of sale and if any economic changes occur between the sale of a comparable and date of appraisal
c) Terms and conditions of sale. For example, if the seller was under pressure to sell the property or if it was sold between friends or relatives
d) Physical features such as the parking lot size, landscaping, type and quality of construction, number of rooms, type of rooms, carpet area of living space, garage, kitchen upgrades, etc.
2) Cost approach
This approach is used for properties that are not sold frequently or those that do not generate income such as schools, churches, hospitals and government buildings. This method uses separate estimates for building and land, taking into consideration depreciation. The estimates are added to calculate the value of the entire property. This approach works under the assumption that a reasonable buyer would not put in extra cash for the property when they can buy a comparable lot or construct a comparable building.
Building costs can be estimated in several ways – one is 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 second method is the unit-in-place method, where costs are estimated based on the construction cost per unit of the individual building components including labour and materials. The third method is the quantity-survey method, which estimates the quantities of raw material that will be needed to replace the subject building, along with the current price of the materials and associated installation costs.
Depreciation
For appraisal purposes, depreciation implies any condition that negatively affects the value of a property. It could include:
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- Physical deterioration including curable deterioration such as roof replacement, painting the building, etc, and incurable deterioration such as structural issues
- Physical or design features that are no longer considered desirable by future property owners such as outdated appliances, dated-looking fixtures, more rooms with one bath, etc, that are referred to as functional obsolescence.
- Factors such as being located near to an airport or polluting facility, referred to as economic obsolescence.
How cost approach works
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- Estimate value of land using sales comparison approach as land cannot be depreciated.
- Estimate the current cost of constructing the building or buildings and site improvements.
- Estimate the amount of depreciation due to functional and economic obsolescence.
- Deduct the depreciation from estimated construction costs.
- Add estimated value of the land to the depreciated cost of the building or buildings and site improvements to determine the total value of the property.
3) Income capitalisation approach
Often referred to as an income approach, this is used to estimate the value of income-generation properties such as apartments, office buildings and shopping centres. This method is based on the relationship between the rate of return an investor requires and the net income that a property produces. The approach is rather straightforward wherein the subject property is expected to generate income when its expenses are predictable and steady.
Appraisers will consider the following steps in this approach:
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- Estimate the annual potential gross income
- Take into consideration rent collection losses to determine effective gross income
- Estimate the price that a typical investor would pay for the income produced by the particular type and class of property. This is got by estimating the rate of return or capitalisation rate.
- Apply the capitalisation rate to property’s annual net operating income to form an estimate of a property’s value. Net operating income is the calculation used to analyze the profitability of income-generating real estate investments. NOI is all revenue from the property minus all reasonably necessary operating expenses.
4) Gross income multipliers
Gross income multiplier or GIM method is used to appraise properties that are not purchased as income properties but that can be rented, such as one and two family homes. Gross monthly income is used for residential properties, while gross annual income is used for commercial and industrial properties.
Sales price divided by rental income = Gross income multiplier
Recent sales and rental data from at least three similar properties can be used to establish an accurate GIM.
Rental income x GIM = Estimated market value
Real property metrics are important for mortgage lenders, investors, insurers, buyers and sellers of real property. While they are conducted by skilled and trained professionals, anyone involved in real estate activities will benefit from having a fair knowledge of different methods used.
Commercial real estate investment analysis
Valuing commercial real estate is probably the most significant factor in determining whether or not to include it in your investment portfolio. The ability to evaluate acquisition properties and one’s own holdings is a skill that every commercial real estate investor must possess.
Property valuations matter due to several reasons. From the buyers’ viewpoint, an accurate valuation helps them pick up a property at reasonable market value and it ensures that they do not overpay for an asset. Similarly, valuation helps sellers price their properties at a level where they can maximize their returns from sale and also make sure that their property is sold in stipulated time.
Valuation is also vital when it comes to financing. Lenders and banks will loan money only when the property is sufficiently valuable to be considered as collateral and can generate necessary revenues to pay off the loan. Investors, real estate professionals, finance professionals conduct valuations based on various factors such as property’s characteristics, property type, location, intended use, etc.
Similar to home real estate valuation, commercial real estate valuation too depends on value, utility, demand, scarcity and transferability.
Methods to evaluate commercial real estate
a) Cost approach: This determines the value of a subject property as the price of the land plus the construction costs for erecting a building. This works on the assumption that cost of the property is based on optimal usage. For example, if one has fertile agricultural land with good water supply, then the cost approach would consider that the land would be used for agricultural purpose vis-a-vis residential or shopping. This also means that this approach is susceptible to zoning laws and changes, which in turn can impact the allowed usage, potential cash flow and income generation potential of a property. Lenders usually use this approach for new construction projects. However, it does not take into account the income the property would generate in future or the prices of similar comp properties.
b) Income capitalization approach: This method puts the future benefits as top priority. Income approach determines value by taking into account the market rent that a property can generate along with potential resale value of a property. Hence income is a primary determiner in this type of valuation.
c) Sales comparison approach: Commonly used in multi-family and residential sectors, this approach uses recently sold comparable properties and asking prices of listed properties as data points to determine the current value of a similarly appointed property. However, this method does not work well with unique or one of a kind properties that have few comparables. Also, this method does not take into account vacancies, losses from collection, unforeseen repair or maintenance expenses that can thwart its accuracy.
d) Value per gross rent multiplier: According to this method,
Property value = Annual gross rents x the gross rent multiplier.
For this calculation to work, it is essential to know the gross rent multiplier of nearby comparable properties. The data can be obtained from investor groups, real estate professionals and even online resources. If one is looking for a simple valuation method to be used in tandem with other approaches, then GRM is worth consideration.
e) Value per door: This valuation method takes the total value of a comparable building and divides that amount per door to come up with a point of reference for another comparable property. It is fast and easy like GRM, though it is not as reliable as other valuation methods.
However, it is important to remember that the above-mentioned approaches are better based on the situation. Just like a craftsman uses all the tools at his disposal, so must a real estate valuator.
For example, a property that is attracting a lot of buyers could use the sales approach while a property with lots of similar comps would do best if it uses the value per door approach.
