Real Estate Valuation Fundamentals & Appraisal Process

Posted on Sep 14, 2024 in Economy

Valuation Fundamentals: Market Value

Market value is the most probable price a property will sell for under the following conditions:

  • Buyer and seller are typically motivated.
  • Parties are well informed/well advised and acting in their best interest.
  • Reasonable time in the market.
  • Payment in cash or its equivalent.
  • Traditional financing.

The Appraisal Process

The appraisal process is performed by appraisers and others seeking to establish value. It involves:

  • Physical and legal identification of the property.
  • Identifying property rights to be valued.
  • Specifying the purpose of the appraisal.
  • Specifying the effective date of the value estimate.

The Three Approaches to Valuation

There are three primary approaches to real estate valuation:

  1. Sales Comparison Approach: This approach compares the subject property to similar properties that have recently sold.
  2. Income Capitalization Approach: This approach estimates value based on the property’s potential to generate income.
  3. Cost Approach: This approach estimates the cost to replace or reproduce the property, less depreciation.

Income Approach Methods

There are three methods for the income approach:

  1. Gross Income Multipliers (“GIM”)
  2. Direct Capitalization Method
  3. Discount Present Value Method

Cost Approach

The cost approach involves the following steps:

  1. Estimate the construction cost of the property if it were new.
  2. Account for physical deterioration, functional obsolescence, and/or external obsolescence.
  3. Add the land cost.

The rationale is that no informed buyer would pay more for a property than it would cost to build a new one. This assumes they considered the time to construct a new asset and the relative risks of ground-up development.

Economic Rationale and Best Use of the Cost Approach

The cost approach is based on the principle that an informed buyer wouldn’t pay more for a property than it would cost to build a new, equivalent one. It’s most reliable when the structure is relatively new and depreciation is minimal.

Economic Rationale, Necessary Information, and Comparability in the Sales Comparison Approach

The sales comparison approach relies on the principle that an informed investor wouldn’t pay more for a property than what others have recently paid for comparable properties. It requires data from recent sales of similar properties. Comparability considers factors like size, location, age, condition, and features.

Capitalization Rate and its Derivation

A capitalization rate is the rate of return on the overall property (debt and equity). The band of investment approach is one way to derive it. This involves calculating a weighted average of the equity dividend rate expected by the investor and the mortgage loan constant required by the lender.

Relationship Between Discount Rate and Capitalization Rate

A capitalization rate equals the difference between the discount rate and the expected growth in income. It ignores changes in income over the property’s economic life.

Unit of Comparison and its Importance

A unit of comparison is used in the sales comparison approach. Adjustments are made to account for differences in size, scale, location, age, and quality of construction between the subject property and comparable properties. This ensures a more accurate valuation.

Depreciation in the Cost Approach

Depreciation in the cost approach encompasses three categories:

  1. Physical deterioration: Wear and tear over time.
  2. Functional obsolescence: Loss in value due to outdated design or features.
  3. External obsolescence: Loss in value due to factors outside the property, like neighborhood decline.

These can be difficult to determine and often require the expertise of specialized appraisers.

Terminal Cap Rate vs. Going-in Cap Rate

A terminal cap rate may be lower than the going-in cap rate if interest rates are expected to fall, risk is expected to decline, or demand is expected to increase between the present and the end of the holding period. Conversely, a higher terminal cap rate would result if the opposite changes occurred.