Real Estate Valuation Methodology
Professional real estate appraisers participate in and offer consultations for various decisions about real estate.
Market value estimates are the most frequent type of appraisal assignment. However, appraisers are called upon to provide a wide range of additional appraisal services, from consultation to various forms of decision-making, because of their specialized training and experience.
An appraisal is based on selective research into appropriate market areas, such as:
- the assemblage of pertinent data,
- the application of appropriate analytical techniques, and
- the acquisition of knowledge, experience, and professional judgment necessary to develop an appropriate solution to a problem.
The Three Approaches to Valuing Real Estate
There are three internationally accepted methods for measuring a property’s value: the cost approach, the sales (direct) comparison approach, and the income approach. Depending on the nature of the property being valued, one or more of these approaches may be used by the appraiser.
Cost Approach
The cost approach is based on the idea that market participants correlate value to cost. The approach derives a property’s value by (a) adding the estimated value of the land to the current cost of constructing a reproduction or replacement for that land’s improvements and then (b) subtracting the amount of depreciation accrued by the property’s improvement(s), regardless of cause. The current cost of constructing improvements can be obtained from cost estimators, cost manuals, builders, and contractors. There are three types of depreciation (physical deterioration, functional obsolescence, and external obsolescence) which can be measured by conducting market research and applying specific procedures. Entrepreneurial profit and/or incentive may be included in the indicated value. Land value is estimated separately in the cost approach.
The cost approach is particularly useful for valuing new or nearly new improvements and properties not frequently exchanged in the market. Costing approach techniques can also be used to obtain information needed for the direct (sales) and income capitalization approaches to value, such as adjusting cost to cure items subjected to deferred maintenance.
This approach is particularly useful in valuing new or nearly new improvements and properties that are not frequently exchanged in the market. Cost approach techniques can also be employed to derive information needed in the sales comparison and income capitalization approaches to value, such as an adjustment for the cost to cure items of deferred maintenance.
Sales (Direct) Comparison Approach
The sales comparison approach is most useful when a number of similar properties have recently been sold or are currently for sale in the subject property’s market. The approach requires the appraiser to develop an indicated value by comparing the subject property to similar properties, called comparable sales. The sale prices of the properties deemed the most comparable tend to indicate a range within which the subject’s value indication will fall.
The appraiser estimates the degree of similarity or difference between the subject property and the comparable sales by considering various elements of comparison:
- Real property rights conveyed
- Financing terms
- Conditions of sale
- Expenditures made immediately after purchase
- Market conditions
- Location
- Physical characteristics
- Economic characteristics
- Use/zoning
- Non-realty components of value
Dollar or percentage adjustments may be applied to the known sale price of each comparable property to derive a range of value indications for the subject property. Through this comparative procedure, the appraiser ultimately arrives at an opinion of value. Income multipliers and capitalization rates may also be extracted through the analysis of comparable sales, but these factors are not regarded as elements of comparison in the sales comparison approach. Instead, they are usually applied in the income capitalization approach.
Income Approach
Income-producing real estate is typically purchased as an investment, and earning power is the critical element affecting property value from an investor’s point of view. In the income capitalization approach, value is measured as the present value of the future benefits of property ownership. There are two methods of income capitalization: direct capitalization and yield capitalization. In direct capitalization, the relationship between one year’s income and value is reflected in either a capitalization rate or an income multiplier. In yield capitalization, the relationship between several years’ stabilized income and a reversionary value at the end of a designated period is reflected in a yield rate. The most common application of yield capitalization is discounted cash flow analysis. Given the significant differences in how and when properties generate income, there are many variations in both direct and yield capitalization procedures.
For the income capitalization approach, the specific data an appraiser investigates might include the property’s gross income expectancy (based on either market or contract rent); the expected reduction in gross income caused by vacancy and collection loss; the anticipated annual operating expenses; the pattern and duration of the property’s income stream; and the anticipated reversionary value. After income and expenses are estimated, the income streams are capitalized (by applying an appropriate rate or factor) and then converted into a present value (through discounting). The rates used for capitalization or discounting are derived from acceptable rates of return. In discounted cash-flow analysis, the quantity, variability, timing and duration of a set of periodic incomes, and the quantity and timing of the reversion are specified and discounted to a present value at a specified yield rate.
Valuation Process
Each real property is unique, and many different types of value can be estimated for any single property. Although property characteristics differ widely, most appraisal problems can be solved through a systematic valuation process.
The valuation process follows specific steps, the number of which depends on the nature of the appraisal assignment and the data available to complete it. In all cases, the valuation process defines the patterns to be followed when performing market research and data analysis, when applying appraisal techniques, and when integrating the results of these analytic activities into an estimate of defined value.
A typical appraisal assignment estimates market value; the valuation process contains all the steps required to complete such assignments, and provides the framework within which any other defined value can be estimated. Furthermore, conclusions for consulting assignments often necessitate deriving value estimates through applying the valuation process.
This valuation process does the following:
- Defines the problem;
- Plans the work necessary to solve the problem; and
- Acquires relevant data and classifies, analyzes, interprets, and converts this data into an appropriate estimate of value.
Ultimately, the valuation process answers questions clients have about real property value.
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