The true market value of a property is one of the most valuable pieces of information for an investor aiming at double-digit profits.
This is defined as the price (cash or equivalent) that a buyer can be reasonably expected to pay and a seller can be reasonably expected to accept, if the property is disposed for sale on the open market for a reasonable period of time, with both buyer and seller being aware of all pertinent information that affects the value of the property, and neither being under any compulsion to act.
There are three major methodologies for estimating property value:
1) The sales comparison approach
2) The income capitalization approach
4) The replacement cost approach
Each of these methods is briefly discussed below.
Sales Comparison Approach
The sales comparison approach uses recent sales of comparable properties in the local market in which the property is competing for buyers. Given that no two properties are exactly the same in terms of their physical, locational and other characteristics, the sales prices of the comparables need to be carefully adjusted to reflect their differences from the property for which the value is being estimated. For example, if the property that is appraised has poorer access than the comparable property then the comparable price will be adjusted downwards by a percentage, based on the judgment of the valuer as formulated by his knowledge of market pricing and variations in prices as a result of variations in access advantages.
If the valuer has information on sufficient transactions of comparable properties, then advanced econometric models and techniques (hedonic regression techniques) can be used for the quantification of the adjustments in value that need to be made for differences in each of the property characteristics/attributes that affect value.
Income Capitalization Approach
The income capitalization approach is typically used for properties that produce income. The simplest version of the income capitalization approach derives the value of a property by dividing the Net Operating Income (NOI) of the property with themarket capitalization rate. A more full mathematical model for estimating the value of a property based on the expected cash flows to be received over the holding period is the Discounted Cash Flow (DCF) model that estimates the present value of all cash flows of the property over its expected holding period taking into account all revenues and expenses, as well as the sales price and costs at the end of the holding period.
The Replacement Cost Approach
The replacement cost approach is used only for providing an indicative figure of how much it would cost to reproduce the property at the time of valuation, and not really as an indicator of market value. For example, the replacement cost of a newly build-house would be equal to its total development cost plus the value of the land.
Residual Valuation Approach
The residual valuation approach is usually used in the case of land sites that can be developed to a particular use. In such cases, the land value is estimated as the residual amount after deducting from the expected sales price of the developed property all development costs and the average return required by investors in the marketplace at the time of the valuation. Whatever is the remaining amount, it represents the price that the average investor would pay to acquire the site. The expected sales price of the developed property can be estimated using the simple income capitalization approach in the case of income producing properties.
Property Value and Economic Theory
A property’s value represents in essence the market price that a buyer would pay in order to acquire the property under conditions of an arm’s length transaction.
According to conventional economic theory, market prices are determined from the interaction between demand and supply. When demand for property equals the supply of properties then market prices and, therefore, market values remain stable. This is what the economists describe as equilibrium market price.
If demand is not equal with supply, or in economic terms, if the market is in disequilibrium, then market prices and market values should be decreasing or increasing towards the equilibrium price, depending how demand relates to supply. In particular, if demand for property exceeds supply, then market prices and, therefore, market values are increasing. On the contrary, if supply exceeds demand then market prices and market values should be declining
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