When it comes to real estate investing, the first thing that comes to a real estate investor’s mind is how much money he/she should pay for certain real estate property. Pricing the real estate property is called property valuation. Property valuation is the process in which the economic value of an investment is determined, which often seeks to determine the fair market value of a real estate property. The rental value of the property is also called as its fair market value. Various factors such as mrket conditions, location, etc. influences the fair market value of the property.
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Valuation of a real estate property can be done using the following methods:
Comparable Sales Approach:
This method is the most popular method used in valuing a property. This method is mostly used for the valuation of land and residential real estate. Valuation is done by comparing the property with similar properties that have been sold within the year under ordinary market conditions. As all the properties which are used in the comparison are not the same, some adjustments need to be done, The adjustments are based on various factors. The most important of all the factors is the location. Location is the factor that significantly influences the sales price of the properties. Other aspects such as square footage, the number of bedrooms, the interior of the property also play a vital role.
Let us take the case of a Property A that has to be valued using the Comparable Sales Approach.
The value of 3 similar properties X, Y, and Z is available in the market. Taking square feet as a variable the value of property A has been computed by determining the average value per square feet of the 3 properties X, Y and Z,(1400 per sq.feet).
Income Capitalization Method:
This is an absolute value method for valuation. There are two variants in this approach.
i)Direct Capitalization Method ii) Discounted Cash Flow Method
The advantage of using this method in comparison with the sales comparison method is that the value which is derived in this method is based on the property that is being valued and not based on the other properties. As a result, this method is much accurate when compared to the earlier method as this method is based on the relationship between the Net income that the property produces and the rate of return the investor wants.
i) Direct Capitalization Method:
The person conducting appraisal should at the first instance estimate the annual potential gross income by taking note of vacancy costs and other costs such as annual operating costs, bad debts, etc. The appraiser should then determine the rate of return, growth rate and compute the value of the property
V = Value of the Property
NOI =Net operating Income
C =Capitalization Rate
G =Annual Growth Rate
Example: Following is the data pertaining to Property Y. Capitalization Rate is 10% and the growth rate id 5%
The value of the property is
ii)Discounted Cashflow Method:
This method is used when the Rental Income derived in each year varies. The income is computed by individually forecasting the revenue and expenses associated with the property over a foreseeable future, computing the terminal value, and discounting the cash flows using the required rate of return. The required rate of return is the discount rate which correctly captures the risk.
Following is the formula for the discounted cash flow method:
The following table shows forecasted NOI:
The growth rate in revenue is 7% per annum and the growth rate is 5% from year 6 onwards.
*The terminal value is calculated using the direct capitalization
This approach is most commonly used for properties that are not easily sold such as schools, hospitals, etc. This approach considers the cost of land and the replacement cost including the construction costs minus the depreciation. The land cost can be ascertained using the sales comparison approach while the replacement costs can be computed in many ways. The most common approach is the ascertainment of the cost to build a square foot of comparable properties multiplied by the total footage of the property.
Example: If the market value of land is Rs.2,00,00,000 and the construction cost is Rs.1,00,00,000. In this case, the current value of construction can be ascertained by adjusting the historic cost for inflation.
Say the rate of inflation is 2.5% and the number of years is 10.
Then the value of land is as under
Property valuation can be done by any of the mentioned methods. The most appropriate approach has to be followed depending upon the features of the property.