Estimating the value of a property in real estate is crucially important for purchasing or selling an investment property, investment analysis, and investment’s insurance and taxation. However, what is property valuation? Why is it important and how to conduct property valuation for real estate investing?
What Is Property Valuation?
Property valuation, or real estate appraisal, is simply a professional estimation of a property’s value in a specific period of time conducted by professional real estate appraisers. Real estate property’s value includes the future benefits and perks derived from real estate property; hence, the valuation of real estate property should take into account the market value’s changes, location, expected future demand, environmental conditions and economic trends. There are many factors that affect the property valuation including but not limited to: the condition of the property, location, its size, construction quality, usability, maintenance of the property, and real estate market value.
Why Is Property Valuation Important?
Many real estate investors and homebuyers turn to banks and/or money lenders for mortgages. These lenders require property valuation to make sure they are not giving a loan greater than the property’s value as this is an essential part of loan’s approval. Property buyers also need to reduce the risk of buying a property at a value more than it deserves, while it is also important for property sellers to price their properties in proportion to the market value and the demand on them. There are different methods used to conduct property valuation for real estate investing depending on the nature of the property and the market at the time of valuing the property.
Related: What do you need to know about real estate property valuation?
Comparable Sales Approach
Comparable sales approach is a method used to value properties by comparing them to recent sales and/or transactions of other similar properties. As every real estate property is unique on its own, the value in CSA takes into consideration the differences between the comparable properties focusing on the general aspects of the property in order to estimate its current market value such as:
- Location
Real estate property values are different based on properties’ locations and whether they are near urban or rural areas, cities, transportation hubs, stores, and shops. It is known that the more strategic the location of a property, the higher its value will be.
- Condition of the Property
Another factor that is taken into account is the condition and the age of the property. A fully furnished property or a newly constructed building will definitely price higher in the market comparing to other older ones, which also goes hand in hand with the construction age of the property as well as its size. There is no doubt that the bigger the property is, the higher its value will be depending on where we are at in the real estate market. Old properties, on the other hand, have less market value due to the maintenance and repair costs associated with them.
Related: Comparative Market Analysis: Real Estate Investing
Net Operating Income Method (NOI) Approach
The net operating income method is a valuation approach that focuses on calculating the generated net operating income by estimating the property’s gross expected annual income for different types of properties such as commercial and residential properties. This method also takes into account some factors that affect the property, including vacancy rates for instance. If a property’s value is estimated to be $700,000, and there is a vacancy rate of 5%, the estimated value is adjusted by subtracting the vacancy rate from its total value.
However, this method does not subtracts costs associated with depreciation, finance costs, and income taxes. It only subtracts operating expenses related to repairs and maintenance, insurance, utility costs, etc. in order to get the expected annual NOI. The next step will be finding the capitalization rate (cap rate) you are expecting from the investment property to generate, which equals the discount rate minus the growth rate. After that, the expected annual NOI should be divided by the cap rate to estimate the value.
Example: An apartment would earn $300,000 (fully occupied)
7% vacancy rate + 3% other estimated losses
Operating expenses (maintenance, insurance, utility costs, etc.) = $50,000
15% required return on investment
Expected NOI= Earn price – Expenses
$300,000 – $50,000 = $250,000
Value = Expected annual NOI/Required return on investment = $250,000/0.15 = $1.6 million
Note: If you are given the price and the expected NOI, you can estimate the return on investment rate using the same method.
Replacement Cost Approach
The replacement cost method estimates the property valuation by estimating the costs of rebuilding the entire property using current construction costs and standards available in the market. The estimated costs in the replacement cost method include:
- The value of the land on which the property is built
- Building materials costs
- Labor costs
- Engineering and design costs
- Legal charges
- Insurance costs
Who Conducts Property Valuation?
As you noticed from the above-mentioned methods, an accurate property valuation needs professional knowledge and education. Not any real estate investor can accurately estimate property valuation, that is why it is conducted by professional appraisers who study the booms and busts of the market, different features of real estate properties, and comparative market analysis. A real estate appraiser is a qualified and trained person who has appropriate analytical and professional skills with respect to real estate properties’ valuation. He/she acquires these skills from appropriate training and certain courses related to the field of property valuation, its duties, and responsibilities.
Related: How to Become a Real Estate Appraiser
Bottom Line
Estimating real estate property valuation is highly important for property buyers, sellers, and mortgage lenders before taking the decision to purchase, sell, or invest in a certain property. Property valuation, consequently, requires knowledge of market value and real estate investment in general. Even though property valuation is a process conducted by professional and specialized appraisers who have the needed skills to value a certain property within the context and value of the market and the features of the property itself, as real estate investor, buyer or seller, you should be familiarized with the basic methods and factors considered when conducting property valuation.
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