While purchasing a real estate property, it is primary and essential to estimate the value for various endeavours, incorporating areas of financing, sales listing, investment analysis, property insurance, and taxation..
On the other hand, most people find ascertaining the purchase price of the property to be the most useful application of real estate valuation..
Let’s find out which approach works the best. In this article, we will determine the basic concepts and methods of real estate valuation.
Before beginning to understand the concept, it is important to know
- Evaluating real estate is challenging since each estate has different features such as location, lot size, floor plan, and amenities.
- Comprehensive real estate market theories like supply and demand in a given region will play into a particular property’s overall value.
- Individual properties must be subjected to evaluation, using one of several methods, to determine a fair value of the property.
Basic Valuation Concept
If we consider all the technical terms, we can interpret a property’s value as the present worth of future benefits arising with the benefits of having ownership on the property. But unlike many consumer goods that quickly come into use, the benefits of real property are generally recognised over a long period. Therefore, an evaluation of a property’s value must take into attention the future and ongoing economic and social trends, as well as governmental controls or regulations and environmental conditions that may influence the four elements of value
- Demand: the desire or need for ownership backed by the financial means to satisfy that need.
- Utility: the ability to fulfil future owners’ expectations and needs.
- Scarcity: the finite supply of competing properties.
- Transferability: the ease of transferability of ownership rights.
Value Versus Cost And Price
It is necessarily prominent that the property value is going to be equal to cost or price.
Cost: applies to actual expenditures – on materials, for example, or labour. Whereas, price is the amount that you pay to purchase it.While cost and price can influence value, they do not determine value.
The sales price of a house can be around RS. 25,00,000, but the value could be significantly higher or lower; This situation occurs if a new owner finds some sedate flaw in the house, such as a faulty foundation or Illegal sources of electricity etc. The value of the property could be lower than the price.
An evaluation is an opinion or estimate, concerning the value of a particular property as of a specific date. Estimation reports are used by businesses, government agencies, individuals, investors, and mortgage companies when making settlements regarding real estate transactions.
The fundamental goal of this appraisal is to determine a property’s market value. The most feasible price that the property will bring in a competitive and open market.
A critical appraisal depends on the systematic accumulation of data. Precise data, including details about the particular property, and general data, concerning the nation, region, city, and neighbourhood wherein the property is located. All of these are collected and analysed to arrive at a value.
Appraisals use three basic approaches to circumscribe a property’s value.
Method 1: Sale Comparison Approach
The sales comparison approach is basically useful in valuing single-family homes and land. Frequently called the market data approach, it is an estimate of value determined by analysing a property with freshly sold properties with similar characteristics. These similar properties are referred to as comparables, and to provide a valid comparison, each must:
- Be as similar to the subject property as possible
- Have been sold within the last year in an open, competitive market
- Have been sold under typical market conditions
- While selecting comparables consider the size, comparable features and – perhaps most of all – location, which can have a huge effect on a property’s market value.
Method 2: A cost approach
The cost approach comes handy when you need to estimate the value of properties that have been improved by one or more buildings. This method involves separate estimates of value for the building(s) and the land, taking into consideration depreciation. The estimates are added together to calculate the value of the entire improved property. The cost approach assumes that a prudent buyer would not pay more for an existing improved property than the price to buy a similar lot and construct a comparable building. This approach is useful when the property includes schools, churches, hospitals and government buildings that are being appraised, is a type that is not frequently sold and does not generate income.
For appraisal purposes, depreciation refers to any condition that negatively influences the value of an improvement to real property, and takes into attention:
- Physical decline, including curable deterioration, such as painting and roof replacement, and incurable cost declines, such as structural problems
- Functional obsolescence refers to the physical or design features that are no longer considered desirable by property owners, such as outdated appliances, dated-looking fixtures or homes with four bedrooms, but only one bathroom.
- Economic obsolescence, caused by factors that are external to the property, such as being located close to a noisy airport or polluting factory.
Method 3: Income Capitalisation Approach
Frequently called the income approach, this method is a bond of relationship between the rate of return, an investor claims and the net income that a property produces. It is useful to estimate the value of income-producing properties such as apartment complexes, office buildings, and shopping centres. Appraisals using the income capitalisation method can be reasonably straightforward when the subject property is under anticipation to generate future income, and when its values are predictable and steady.
Several steps are taken under consideration when using the direct capitalisation approach:
- Estimate the annual anticipated gross income.
- Take into consideration vacancy and rent collection losses to determine the effect on gross income.
- Deduct annual operating expenses.
- Calculate the annual net operating income.
- Estimate the price that a typical investor would pay for the income produced by the particular type and class of property.
- Apply the capitalisation rate to the property’s annual net operating income to form an estimate of the property’s value.
Gross Income Multiplier
The gross income multiplier (GIM) method is useful to appraise other properties that are typically not purchased as income properties, but that could be rented, such as one- and two-family homes.
In the case of residential properties, the gross monthly income is considered for commercial and industrial properties. The gross income multiplier method can be calculated as follows:
Sales Price ÷ Rental Income = Gross Income Multiplier
And so the recent sales and rental data from at least three similar properties can be used to establish an accurate GIM. The GIM can then be utilised to the estimated fair market rental of the subject property to ascertain its market value, which can be calculated through the method below:
Rental Income x GIM = Estimated Market Value
Specific real estate valuation is essential to mortgage lenders, investors, insurers and buyers, and sellers of real estate property. Where appraisals are generally performed by skilled professionals, it is a guarantee that you will be able to make better decisions by gaining a basic understanding of the different methods of real estate valuation.