3 Main Real Estate Valuation Methods
There are several different methods used to value property, but here are the three most common methods:
- Market comparison approach: Compares the property being valued with other similar properties that have recently been sold in that area
- Income or investment approach: Looks at how much income the property being valued is already generating or could potentially generate
- Cost approach: Looks at how much it would cost to build an equivalent property
Each valuation method is independent of the others, meaning an appraiser will mainly use only one approach rather than a combination of all three approaches to determine the value of any one property. The method used may be dictated by the lender in question. And, each approach can arrive at quite different valuations, so it’s important to know which valuation method your chosen lender is using. Different valuation methods are used for different situations.
Sometimes more than one valuation figure is quoted in reports, particularly for commercial mortgages where the market comparison (or bricks-and-mortar) valuation is used as a fallback if the investment valuation use of the building changes (for example, a paying tenant leaves and the income reduces to zero until a new one is found).
That’s not to say that one approach is better than the others — only that one approach will be more applicable or appropriate for a certain property than the others. You need to understand the differences between each approach, and know which approach the appraiser is using for your investment.
Market comparison approach
If a total novice wanted to roughly work out the value of his home before putting it on the market, what would he do? He’d go online and look at how much similar properties nearby (ideally on the same street) sold for. “Well, honey, the Jeffersons at number 59 sold their home six months ago for $280,000, and they only had a single garage, not a double like ours. So, our house is bound to be worth a bit more.” That, in a pretty crude nutshell, is how the market comparison valuation method works.
Also known as market value approach or bricks-and-mortar valuation, market comparison is a valuation method that’s based on local comparables — in other words, how much similar, nearby properties have sold for recently. It’s the most common valuation method and the one typically used by mortgage lenders to assess residential properties.
Common considerations for market comparison valuations
Your average market comparison valuation will define a property’s value by looking at prices of properties on the same street or prices of other properties of a similar size and condition from the local area. The value will be adjusted according to variances like the size, specification, and condition of the property being valued. Other variables may also be factored in, such as supply and demand in the local real estate market at that time or the availability of financing.
In addition, appraisers who are appointed by a lender may also be constricted by the lender’s valuation criteria, which may lean toward the lower end of comparables in order to reduce their risks as much as possible. Therefore, the inherently cautious nature of lenders and appraisers means you won’t necessarily get the valuation you hoped for. Just because the house down the street sold for $280,000 doesn’t mean you’ll get the same valuation.
Of course, no two properties are exactly alike. Properties A and B may be the same size and on the same street, but Property A may have a beautiful view of rolling hills, while Property B may have a rather uninspiring view of other houses. But maybe Property B has been stylishly renovated, while Property A is straight out of the 1970s, complete with peach satin drapes and brown shag carpets. That’s why appraisers try to find a few comparable properties to help them determine a fair market value, not just one or two.
The limitations of market comparisons
If there’s one sticking point with the market comparison approach it’s this: To get an accurate valuation, you do a good number of comparable properties. That’s fine for a standard residential property, like a single-family home or an apartment, where there are lots of similar properties to look at. But when you start to get into bigger, unique properties, finding enough accurate comparable market data is challenging.
Although it’s a straightforward valuation method to understand, the market comparison method isn’t always the best judge of value. Imagine a huge nine-bedroom rental property. Although it is a residential property, the market comparison approach just isn’t reliable because there aren’t any similar nine-bedroom rental properties nearby.
In that example, the first two valuers, who were using the market comparison approach, had to look at larger properties elsewhere in the town. But that wasn’t a fair comparison because the location of my investment property was far more desirable. Essentially, the property was unique in that market, meaning the market comparison approach just wasn’t a reliable indicator of value, so these valuers took a cautious approach. For that investment, the income approach was much more appropriate.
Income or investment approach
Instead of looking at the bricks-and-mortar value of a property, this valuation method treats the property as an income-producing business.
Focus on income not comparables
The income approach or investment value approach to valuation assesses the value of a property as an investment. Also known as commercial investment valuation, this method is commonly applied to commercial properties like offices, but it may also be used for income-producing residential properties, such as rentals or blocks of apartments.
At its heart, the income approach is based on the understanding that the higher the income potential of a property, the more an investor is willing to pay for it. A property’s income or investment valuation can be higher or lower than its market comparison value — in my experience, it’s often (but not always) higher.
How the income approach works
The best way to describe how this valuation method works in practice is with an example. The example is based on a UK investment: a small block of four apartments.
Let’s say each of the apartments is rented out for £750 per month. That’s a gross annual rental income of £36,000. Now, based on her appraisal of the property, the UK valuer will apply two concepts to arrive at an income-based valuation of that property:
- Discount: A discount that’s applied to the gross income in order to establish a realistic picture of the net income. A discount of 15 percent to 25 percent is typical on a UK income valuation, but it depends on a number of factors, such as the quality of the property, how strong the rental market is right now, location, costs, and how likely it is that one or all the units can stand empty without tenants for a period of time (the void period). Basically, the lower the discount, the better the property. But let’s say the discount applied to our £36,000 annual gross rental income is 20 percent. So, our estimated net income is then £28,800.
- Yield: The return on investment the investor can expect to receive, expressed as a percentage. To determine the yield, the valuer will look at comparable properties, local rental incomes for similar apartments, demand in the local market, and so on. In a busy town with lots of renters, the yield will be better than in a rural setting, with lower demand from renters. Let’s say the yield on our example investment is 7 percent.
To calculate the income valuation, the valuer will take the discounted net rental income (£28,800) and divide it by the yield (7 percent). The income-based value of that block of apartments is therefore £411,429. Valuers will usually round the figure down as well.
Don’t be shy about calling a couple of local surveyors and asking what sort of yield they’re currently applying to your type of investment property in your area. It’s part of my process when I’m evaluating the potential of an investment deal because the end value is so important.
Although this example gives a useful overview of the concept of valuing based on income. The nuances of the income-based approach will depend on which country the investment property is located in. For example, in the United States, a revenue multiplier or capitalization rate (rather than yield) is applied to net income. Always research the income valuation method that’s used in your particular market.
The third approach to be aware of looks at neither income generated by a property nor local comparable properties.
The cost approach is used to establish the cost of replacing the building being valued. It’s widely used for insurance replacement purposes (so, if the building burned down, how much would it cost to replace the building on that spot?), but it can also be a useful method for brand-new buildings, proposed constructions, and unique properties that don’t have local comparables and don’t generate an income.
When using the cost approach, an appraiser will look at the estimated value of the land, as well as the cost to replace the building as new (minus depreciation, such as wear and tear).