Meaning of Real Estate Valuation

An accurate valuation or appraisal of a real estate property is crucial for making wise investment decisions. Some real estate investment companies have entire teams whose main purpose is to determine the value of new real estate opportunities and the company’s current real estate assets.

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Key Takeaways

  • Real estate valuation determines the current market value of the real estate and how much an investor should pay for this asset. Commercial real estate valuation enrolls teams of people to determine the value of a property. Real estate valuation companies use three approaches: A sales comparison, cost, and income. Typically, an appraiser or anyone looking to evaluate real estate would use a blend of these three approaches in order to come up with as accurate a value estimate as possible.Valuators and appraisers who provide real estate valuation services use a specific blend and weight for each approach depending on the asset class and expected use for the real estate.

Methods to Value Real Estate 

Real estate valuation is often done by appraisers, property valuers, or surveyors. In addition, there are real estate valuation companies doing commercial real estate valuation who appoint them. The appraisers and other parties use three different methods to determine the real estate value. Some assets may use one method primarily, but in most cases, a blend of all three is considered.

The three approaches for evaluating real estate are described below:

#1 – Sales Comparison Approach

One can get an estimate of value by comparing the subject property with recently sold properties (called comps). This approach is best for residential real estate. Typically one should select at least three comps within a mile that sold less than six months ago. Since no two properties are identical, we must make adjustments for the differences and similarities in the comps. It should be based on property rights, sale conditions, physical features, sale date, and other varying details.

#2 – Cost Approach

This approach uses five steps to value a property based on the cost to construct it. Valuers use it to appraise special purpose or newer buildings where the most relevant costRelevant CostRelevant cost is a management accounting term that describes avoidable costs incurred when making specific business decisions. This concept is useful in eliminating unnecessary information that might complicate the management’s decision-making process. For example, businesses use relevant costs in management accounting to conclude whether a new decision is economical.read more is to construct/replace the property.

  • Estimate the value of the land as if it were vacant and available for its best useDetermine the current cost of construction of the building and all of its improvementsEstimate any accrued depreciation from the property’s current physical condition, deterioration, and obsolescence.Subtract the accrued depreciation (step 3) from the current construction cost (step 2).Add the land value (step 1) to the depreciated costDepreciated CostDepreciated cost refers to the current worth of a fixed asset after assimilating its used-up value. It is the leftover fixed asset value after deducting the accumulated depreciation from its original cost.read more (step 4) to find the total property value. (i.e., Land+Construction Cost-Depreciation=Value).

#3 – Income capitalization Approach

The income approach values income-producing properties such as apartment buildings or office buildings through five steps:

  • Estimate annual potential gross incomeGross IncomeThe difference between revenue and cost of goods sold is gross income, which is a profit margin made by a corporation from its operating activities. It is the amount of money an entity makes before paying non-operating expenses like interest, rent, and electricity.read more. It is based on market rates, not on in-place revenue (i.e., if an office building has a tenant paying below-market rent, you would use a potential gross income higher than in place).

  • Deduct vacancy and other potential losses to arrive at effective gross income. Determine operating expenses to arrive at the annual net operating incomeNet Operating IncomeNet Operating Income (NOI) is a measure of profitability representing the amount earned from its core operations by deducting operating expenses from operating revenue. It excludes non-operating costs such as loss on sale of a capital asset, interest, tax expenses.read more (NOI). Estimate the rate of returnRate Of ReturnRate of Return (ROR) refers to the expected return on investment (gain or loss) & it is expressed as a percentage. You can calculate this by, ROR = {(Current Investment Value – Original Investment Value)/Original Investment Value} * 100read more a typical investor pays for the income produced by this type and class of property. The rate of return is the capitalization (or cap) rate and one calculates it by dividing the NOI of comps by their sales price. For example, a comp that sold for $100,000 with an NOI of $10,000 would have a 10% cap rateCap RateThe cap rate formula is calculated by dividing the net operating income by the asset’s current market value. The investors use it to evaluate real estate investment based on the return of one year. It helps to decide whether a property is a good deal. Formula = Net operating income/Asset’s current market valueread more.Apply the market cap rate to the subject property. So if the subject property was generating $15,000, you would divide the NOI by the cap rate (0.1) to arrive at a value of $150,000.

Step-by-Step Example

Let’s go through an example of a single-family home in the south suburbs of Chicago. Our property is a 1999 3-bedroom, 2-bathroom home located on a 0.25-acre lot in a subdivision. Here is how we determine its value.

Sales Comparison Approach:

We found three similar homes nearby sold for $150,000, $155,000, and $180,000. The first two homes are identical in features. Upon further examination, the third property sold for $180,000 has a finished basement and is furnished. We deduct $10,000 for furniture and $15,000 for the finished basement from its value to get to an adjusted value of $155,000. Then we would take the average and use that as our estimated value with the sales comparison approach: $153,300. 

Cost Approach:

Raw land sells for $10,000 an acre a few miles down the road, so we estimate our land to be worth $2,500. The construction costs for a home of this size and features, including development costs, are $200,000. Also, this home is 21 years old and has accrued $100,000 of depreciation. Our estimated value with the cost approach would be $2,500 + $200,000 – $100,000, which equates to $102,500. Given the property’s age and the rising costs of construction in the last 20 years in North Carolina, this would not be a very helpful approach because it does not accurately represent the market value or possible income stream we can generate. Therefore, we would not weigh this estimate heavily in our valuation.

Income Approach:

Active listings similar to our home rent for $1,800 a month. Therefore our potential annual income $21,600. We will assume a 5% vacancy loss and another $150 for potential income losses, so our effective gross income is $20,370. Then we deduct our expenses (40%) to get to our Net Operating Income of $12,222. The south suburbs of Chicago is a riskier market for investors and traders at a high cap rate of 8%. Hence, if we divide $12,222 by 0.08, we will get to an estimated value of $152,775.

Final step

We would then blend the three numbers based on the weightage of each approach to get to an estimated value. Given that this home is about to be an investment propertyInvestment PropertyInvestment property refers to the real estate acquired to earn returns on the investment through rental income, royalties, dividends or future appreciation, usually in the name of an individual investor, a group of investors or an investment company for a short-term or a long-term investment.read more, we will weigh the income approach slightly higher and value the property at $153,000.

This has been a guide to What is Real Estate Valuation and how it is done. Learn the real estate valuation methods with the help of step-by-step examples. You can learn more from the following articles –

Real estate valuation or real estate appraisal attributes a particular value or worth to a real estate property. Determining the worth of a property is a major requirement when it comes to weighing investment decisions. The valuation of real estate is done through either of the three approaches( cost, comparison, and income) or a mixture of three.

A person who determines the value of a real estate property through valuation approaches is called a real estate valuation analyst. They are also called appraisers, property valuers, or surveyors.

Real estate valuation is done through three main approaches. They are the cost-based approach, comparison approach, and income capitalization. Appraisers use either one of these processes or a combination of all three to come to a conclusion regarding the property’s current value.

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