Property Valuation: The Basics

In real estate, analysts use many valuation methods to determine the worth of a specific property. Generally, these comparison methods apply to both private and commercial properties. While property valuation is important, other external factors might influence fair market value. In the property insurance industry, home appraisals are basic procedures.

Real estate sellers, buyers, and lenders need be able to determine the worthiness of property so as to make good financial choices. Property valuation is the process which determines the economic value of property. The aim of property valuation is to determine fair market value, the cost at which an informed seller sells her property to a knowledgeable buyer who is willing to purchase it. In other words, it assumes both parties possess all the appropriate information and neither are forced to purchase or sell. Market value is not an indication of the same sales value. For instance, a brief sale of real estate might not attract fair market value because the seller is distressed and has to sell the property straight away. Potential customers know this so they have a bargaining advantage and typically get the deals for less than market value.

Property valuation lies upon four foundational pillars. Demand, the first, is the size of interest and purchasing power in the marketplace for purchasing such property. Utility, the second, is the capability of the real estate to fulfill the use or need of potential purchasers. Scarcity, the next, admits that there’s a limited source of real estate. Transferability, the fourth, describes the ease at which a parcel of real estate can legally be transferred to a new owner.

Let’s analyze the main methods (in no particular order) of property evaluation.

Residual Method of Property Valuation

Any type of property, including this stretch of office leasing spaces can be evaluated with the Residual Method of Valuation. It’s a valuation process of obtaining the residual value for any property that’s under development. Initially, the property valuer assesses the development costs by using different metrics. Like other development components, property owners make statutory payments, legal, and professional fees (developer and estate agent) as preliminary expenses. Other development factors of Residual Method of Valuation include the contingency cost, project management fees, earthworks, and construction of the foundation.

Since the sale of a property depends on its current market value, the residual value will be discounted during the period of development. Also, the gross development value is obtained after comparing the factors (metrics) of the development of the subject property with others in the same locality. Valuers can adjust the proposed selling price of any property that was assessed with the Residual Method of Valuation. Other metrics for price adjustments include the property’s pros, cons, and estimated cost of project completion.

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Sales Comparison Method

In the sales comparison approach, we use real estate market data to determine the value and price trends of any property. Comparing the values of properties with similar features applies to land, commercial, and residential structures. However, similar properties that can be compared must have been sold or ready for sale within that business year. Also, they must be assessed under the same market conditions. Usually, properties under review are called comparables, and their locations are important when you use the Sales Comparison Method.

Real estate appraisers use at least four comparables to determine the right sales price of an investment property. Other metrics include the property’s age, physical features, square footage, and condition of sale.

Income Capitalization Approach

Before investing, do you need to know the projected income, and cost of maintaining any commercial property? Just like in infrastructure construction, or in any types, the income capitalization approach is the last method of evaluating any income-producing property. It applies to commercial properties like shopping malls, cinemas, and office buildings. With the income approach method, potential investors can determine the relationship between their expected returns (on investment), and net income from the property. These are two sub-valuation methods under the income capitalization approach.

Direct Capitalization: The initial process involves estimating the expected annual gross income of the property from rent collection. Then, subtract the annual operating (maintenance) expenses to show the property’s net operating income. Additionally, investors can get the real value after applying the rate of return, and cap rate on the property’s (annual) net operating income.

Gross Income Multipliers (GIM): The second sub-approach (under the income capitalization) applies to properties that were not designed for commercial purposes initially; it could be a residential property or even part of an infrastructure in Australia. A multi-family home might be converted into a commercial building to generate income. However, an investor can determine the properties monthly or annual gross income with the GIM approach. This formula is useful in determining the GIM; Selling Price รท Rental Income = Gross Income Multiplier (GIM). After obtaining the Gross Income Multipliers value, the valuer can calculate the property’s fair market value with this formula.

Rental Income x Gross Income Multiplier (GIM) = Estimated Market Value

Other methods for real estate appraisal are Discounted Cash Flow Approach, Cost Approach, and Profits Method of Valuation.

The Bottom Line

Accurate real estate evaluation is significant to mortgage lenders, investors, insurers and buyers, and sellers of property. While appraisals are usually performed by skilled professionals, anyone involved in a true trade may benefit from getting a fundamental understanding of the various methods of real estate valuation.

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