TOP 3 PROPERTY VALUATION METHODS: HOW MUCH IS YOUR PROPERTY WORTH?
When trying to determine how much your property is worth, it can be confusing to cut through the noise and figure out a realistic answer. Market value really depends on the current market conditions and whether you want to ask lenders, agents or county tax assessors. Although there are many methods of valuation, let’s explore the top 3 property valuation methods used by investors.
In order to make a profit, investors must know how to value real estate and make educated guesses, whether through real estate appreciation, rental income or both. In terms of real estate investment, the first thing that a real estate investor thinks about is how much he/she should pay for a certain real estate. Pricing real estate is called real estate appraisal.
Accurate real estate valuation can help investors make better decisions in buying and selling real estate. Estimating the market value of real estate is necessary for a variety of tasks, including financing, sales listings, investment analysis, property insurance and taxation. For most people, determining the asking price or purchase price of a piece of real estate is the most useful application of real estate valuation. This article will introduce the top 3 property valuation methods of real estate investing, especially those related to sales.
Overview: Top 3 Property Valuation Methods
What is property valuation?
Property valuation (or appraisal) is the process of determining the economic value of a real estate investment, usually trying to determine the fair market value of the real estate property, or the price at which an informed seller is willing to sell his real estate to informed buyers. In other words, both parties have all relevant information, and neither party is forced to sell or buy. However, it must be pointed out that the value of a property does not always equal its price. For example, in some cases, the seller feels distressed and must sell the property immediately even if the price is lower than its fair market value.
Why is Real Estate Appraisal Important?
Property valuation is a very important concept in real estate investment, because it is the main factor in determining how much property taxes and property insurance the owner will have to pay.
In addition, mortgage lenders need to conduct a property valuation before offering loans. The reason for this is to protect potential buyers from excessive costs for real estate purchases and to protect banks from financing real estate with a value lower than their investment. A property assessment is also needed to resolve legal issues like divorce, real estate settlement or litigation.
Basic Valuation Concepts to determine how much is your property worth
The value of property is defined as the present value of future benefits generated by property ownership. Unlike many fast-moving consumer goods, the benefits of real estate are usually realized over a long period of time. Therefore, the estimation of property value must take into account economic and social trends, government controls or regulations and environmental conditions that may affect the four elements of value:
Demand: The desire or need for ownership is supported by financial means to satisfy this desire
Utility: The ability to meet the needs of future owners
Scarcity: Limited supply of competitive property
Transferability: The difficulty of ownership transfer
Value, Cost and Price
Value does not necessarily equal cost or price. Cost refers to actual expenditures, such as materials or labor. On the other hand, the price is the amount someone pays for something. Although cost and price affect value, they cannot determine value. The sale price of the house may be $150,000, but the value may be higher or lower. For example, if the new owner finds that the house has serious defects, such as damaged foundations, the value of the house may be lower than the price.
Valuation is an opinion or estimate of the value of a specific asset on a specific date. Enterprises, government agencies, individuals, investors and mortgage companies use appraisal reports when making real estate transaction decisions. The purpose of this evaluation is to determine the market value of real estate with an unbiased third party opinion based on facts, that is, the most likely price that real estate brings in a competitive and open market.
The market price, the price at which the real estate is actually sold, may not always represent the market value. For example, if the seller is coerced due to the threat of foreclosure, or if a private sale is made, the sale price of the property may be lower than its market value. Conversely, property may sell higher than true market value due to hype or emotions, or lack of inventory.
Top 3 Property Valuation Methods and Their Advantages
Equity valuation is usually carried out through two basic methods: absolute value and relative value. The same is true for property evaluation. Using an appropriate real estate discount rate to discount future net operating income (NOI) is similar to the valuation of the discounted cash flow (DCF) of stocks. Integrating the total income multiplier model into real estate is comparable to the relative valuation of stocks. Below, we will introduce how to use these methods to value real estate.
An accurate assessment depends on collecting data systematically. Specific data related to the detailed information of a specific property, as well as general data related to the country, region, city, and community where the property is located, at the determining factors in deriving value. Our Top 3 Property Valuation Methods use three basic methods to determine the value of a property.
Method 1: Sales comparison method
The sales comparison method is commonly used to evaluate single-family homes and land. Sometimes called the market data method, it is an estimate of the value of real estate by comparing real estate with recently sold real estate with similar characteristics. These similar characteristics are called comparable attributes, and in order to provide an effective comparison, each attribute must:
As similar as possible to the theme attributes
Sold in the highly competitive market opened last year
Already sold under typical market conditions
At least three or four comparable objects should be used in the evaluation process. The most important factors to consider when choosing comparable projects are scale, comparable characteristics, and (perhaps most important) geographic location, which can have a huge impact on the market value of real estate. Of the top 3 valuation methods, this method is our first choice since it identifies what an informed buyer would pay for a comparable property.
Comparable company quality
Since no two attributes are exactly the same, the sale price of comparable objects will be adjusted to take into account different functions and other factors that may affect value, including:
Age and condition of the building
Sale date (if there is an economic change between the sale date of the comparable product and the evaluation date)
Terms and conditions of sale, such as whether the seller of the property is coerced or the property is sold to relatives (sold at a discount)
Geographical location, because similar properties may have different prices in various communities
Physical characteristics include plot size, landscape, type and quality of building, number and type of rooms, square feet of living space, hardwood floors, garage, kitchen upgrade, fireplace, swimming pool, central air, etc.
The market value of the subject property is estimated to fall within the range formed by the adjusted sales price of comparable companies. Since some adjustments to the sales prices of comparable companies will be more subjective than other methods, weighted consideration is usually given to those comparable companies with the least amount of adjustment.
Method 2: Cost method
The cost method can be used to estimate the value of an improved property of one or more buildings. This method involves the estimation of the individual value of buildings and land and takes into account depreciation. These estimates are added together to calculate the value of the overall improvement attribute.
The assumption of the cost method is that a reasonable purchaser will not pay a higher price for the purchase of an existing improved property than for the purchase of comparable batches and construction of comparable buildings. This method is useful when the property to be assessed is of a type that is not frequently sold and does not generate income.
Examples include schools, churches, hospitals and government buildings.
There are several methods for estimating building costs, including the square foot method, where the cost per square foot of a similar building recently constructed is multiplied by the square foot of the theme building; the in-situ unit method, where the cost is based on a single building component labor and materials); and the quantity survey method, which estimates the quantity of raw materials required to replace the subject building, as well as the current material prices and related installation costs.
Method 3: Income Capitalization Method
Usually called the income method, this method is based on the relationship between the return rate required by the investor and the net income generated by the property. It is used to estimate the value of income-generating properties, such as apartment buildings, office buildings, and shopping centers. When the target property can be expected to generate future income, and its expenditure is predictable and stable, the evaluation using the income capitalization method can be very simple – see the example below
When using the direct capitalization method, the assessor will perform the following steps:
Estimate Annual Potential Total Income.
Consider the loss of vacancies and rent collection to determine the effective total income.
The annual operating expenses are deducted to calculate the annual net operating income.
To determine the price that an investor is willing to pay for the property to generate beneficial income, estimate the rate of return or capitalization rate. Apply the capitalization rate to the annual net operating income of the property to estimate the value of the property.
Gross Income Multiplier
The Gross Income Multiplier (GIM) method can be used to evaluate other properties that are not normally purchased as income property but can be rented, such as one- and two-family houses.
For residential properties, the total monthly income is usually used. For commercial and industrial properties, the total annual income is used.
The total income multiplier method can be calculated as follows:
Sales price ÷ rental income = total income multiplier
The latest sales and rent data from at least three similar properties can be used to establish an accurate GIM.
Then, GIM can be applied to the estimated fair market rent of the underlying property to determine its market value, which is calculated as follows:
Rental income x GIM = estimated market value.
These top 3 three property valuation methods are the most commonly used methods. The best method for you will depend on the type and purpose of the asset and the availability of information.
Accurate real estate valuation is very important to mortgage lenders, investors, insurance companies and buyers, and real estate sellers. Although evaluations are usually performed by skilled professionals, anyone involved in real estate transactions can benefit from a basic understanding of the different methods of real estate valuation.
→ For more valuation methods read our blog “Valuation Methods Used in Real Estate Investing – Cap Rate and More!”
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Knowing the basics of property valuation can help you make the best choice for your real estate investments. Here at Veloce Capital, we can help you as you take the first steps into real estate investing. We’ll help you set up an entire plan that works for you from start to finish.
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