Real Estate Valuation – What It is and Why It's Used

Determining a value for real estate is required because the real estate market is not perfect. There is commonly a lack of reliable data, and in some cases, market prices are simply not valid indicators of value. Therefore, when key questions about a property are critical to decision making, an estimate for real estate valuation becomes necessary. For example,

1. A real estate investor might want to determine a possible purchase price for an investment property.
2. A seller may wish to set an appropriate asking price, or perhaps is considering other alternatives such as holding the property, refinancing it, or exchanging it and wants to determine an estimate of his or her available capital or net equity in the present property.
3. A real estate lender would want this information when trying to decide whether to underwrite a loan for a property.
4. Tax assessors also want this information to set an assessed value for the property.
5. Courts that must decide upon the division of property, the awarding of damages or in cases of eminent domain would also be concerned with the value of real property.

Behind it all, of course, is the estimate of “market value”, which is the primary task and concern to most analysts seeking real estate valuation. Before we pursue that, though, we want to first mention that many decisions and questions concerning real estate require the estimate for various other values as well, including

1. Investment value – This is the value a specific investor would attach to real property based upon the investor’s individual requirements, tax rate, ability to finance the property, and so on.
2. Insurable value – This sets a value for those portions of the property that are physically destructible.
3. Assessed value – The value established by the tax assessor for purposes of levying local taxes on real property.
4. Loan value – This is what is used to secure a mortgage for the property.
5. Liquidation value – This is the price that a property would likely bring as the result of a foreclosure or tax sale, or in cases of a forced sale where conditions might not allow for normal time of exposure on the market and would depress the price.

Fair enough. Now let’s consider market value and its role in real estate valuation.

Market value signifies the most probable price that a property would bring in a fair, competitive and open market. That is, when all parties involved act prudently and knowledgeably, and the price is not affected by any undue stimulus such as special or creative financing or perhaps a sales concession granted by someone involved with the sale.

There are three approaches commonly used to estimate market value.

1. Sales Comparison – This approach relies on a principal that assumes that the subject property should have a value that is the same as a similar property. In this case, the analyst compares other similar properties that recently sold and uses those prices to determine a reasonable measurement of value for the subject. It is not an exact science because no two properties are the same. Nonetheless, when differences between the subject and comparables are slight enough, values are attached to those differences, then added and subtracted until the prices are adequately adjusted and a relatively narrow enough price range emerges that can be used to set a market value for the subject property. This is commonly used when setting the price for single-family residences.
2. Cost Approach -The concept here is based on the assumption that a buyer would be unwilling to pay more for any given property than the cost of producing a substitute property. In this case, the cost of the site plus the cost reproducing the building is used to estimate value, or the “replacement value”. The fundamental weakness of this approach is to assume that the cost of creating a building equals its value given that other forces such as supply and demand (ignored in this approach) drive value. This approach, although useful, is seldom used unless there is little or no sales data or rental information (as in the case of income property) available.
3. Income Capitalization – This approach is based on the principal that the value of an income-producing property is the present worth of its future income stream. Those associated with real estate investing are familiar with the term “cap rate” and the formula, net operating income divided by sale price equals cap rate. In this case, a number of income/price ratios are found in the market for similar properties then applied to the subject property. This is probably the most popular method for income-producing properties.

Okay, let’s summarize.

Real estate valuation is used to answer key questions about a property that a multitude of different analysts may ask in order to make a decision about the property. In each case, the bottom line is always the market value for the property-what will someone pay to own the property-and this boils down to several approaches depending on the circumstances surrounding the property.

About the Author

James Kobzeff is the developer of ProAPOD – leading real estate investment software solutions since 2000. Create rental property cash flow, rates of return, and profitability analysis presentations in minutes! Easy and affordable. Learn more at http://www.proapod.com