Jean Folger has 15+ years of experience as a financial writer covering real estate, investing, active trading, the economy, and retirement planning. She is the co-founder of PowerZone Trading, a company that has provided programming, consulting, and strategy development services to active traders and investors since 2004.
Updated August 10, 2024Real estate valuation takes into account many hard facts about a property such as its location, lot size, amenities, and floor plan. Another factor is more difficult to measure, and that is the present value of future benefits that the owner of the property will incur.
This concept is related to the relatively long time commitment and high price of buying real estate. Homeownership is not a casual or short-term commitment for most.
An accurate valuation is important not only to buyers and sellers but to banks that finance the purchases, property insurance companies that protect them, and local governments that tax their owners.
A property's value is defined as the present worth of future benefits arising from the ownership of the property.
Unlike many consumer goods that are quickly used, the benefits of real property are generally realized over a long period of time. An estimate of a property's value must take into consideration economic and social trends, as well as governmental controls or regulations and environmental conditions that may influence the four elements of value:
Value is not necessarily equal to cost or price.
Cost refers to actual expenditures related to the creation and marketing of a product, such as materials, labor, and advertising.
Price, on the other hand, is the amount that someone is willing to pay for the product.
While cost and price can affect value, they do not determine value. The sales price of a house might be $150,000, but the value could be significantly higher or lower. For instance, if a new owner finds a serious flaw in the house, such as a faulty foundation, the value of the house could be lower than the price.
An appraisal is an opinion or estimate regarding the value of a particular property as of a specific date.
Appraisal reports are used by businesses, government agencies, individuals, investors, and mortgage companies when making decisions regarding real estate transactions. The goal of an appraisal is to determine a property's market value, or the probable price that the property will bring in a competitive and open market.
Market price, the price at which property actually sells, may not always represent the market value. For example, if a seller is under duress because of the threat of foreclosure, or if a private sale is held, the property may sell below its market value. If a bidding war breaks out over a property, emotion rather than value may carry the day.
An accurate appraisal depends on the methodical collection of data. Specific data on the property and general data related to region, city, and neighborhood wherein the property is located, are collected and analyzed to arrive at a value.
Appraisals use three basic approaches to determine a property's value.
The sales comparison approach is commonly used in valuing single-family homes and land. Sometimes called the market data approach, it is an estimate of value derived from a comparison with recently sold properties that have similar characteristics.
These similar properties are referred to as comparables. To provide a valid comparison, each must:
At least three or four comparables should be used in the appraisal process. The most important factors to consider are size, comparable features, and – perhaps most of all – location, which can have a tremendous effect on a property's market value.
Since no two properties are exactly alike, adjustments to the comparables' sales prices will be made to account for dissimilar features and other factors that affect value, including:
The market value estimate of the property will fall within the range formed by the adjusted sales prices of the comparables. Since some of the adjustments made to the sales prices of the comparables will be more subjective than others, weighted consideration is typically given to those comparables that have the least amount of adjustment.
The cost approach can be used to estimate the value of properties that have been improved by the addition of one or more buildings. This method involves separate estimates of value for the building(s) and the land, taking into consideration depreciation. The estimates are added together to calculate the value of the entire improved property.
The cost approach starts with the assumption that a reasonable buyer would not pay more for an existing improved property than it would cost to buy a comparable lot and construct a comparable building. This approach is useful when the property being appraised is a type that is not frequently sold and does not generate income, such as schools, churches, hospitals, and government buildings.
Building costs can be estimated in several ways, including the square-foot method where the cost per square foot of a recently built comparable is multiplied by the number of square feet in the subject building; the unit-in-place method, where costs are estimated based on the construction cost per unit of measure of the individual building components, including labor and materials; and the quantity-survey method, which estimates the quantities of raw materials that will be needed to replace the subject building, along with the current price of the materials and associated installation costs.
For appraisal purposes, depreciation refers to any condition that negatively affects the value of an improvement to real property. It takes into consideration:
Often called simply the income approach, this method is relevant only for valuing property for investors seeking a return from the use of a property.
The income approach is based on the relationship between the rate of return an investor requires and the net income that a property produces. It is used to estimate the value of income-producing properties such as apartment complexes, office buildings, and shopping centers.
Using the income capitalization approach can be fairly straightforward when the subject property is expected to generate future income and when its expenses are predictable and steady.
Appraisers will perform the following steps when using the direct capitalization approach:
The gross income multiplier (GIM) method can be used to appraise properties that are typically not purchased as income properties but that could yield rental income, such as one- and two-family homes. The GRM method relates the sales price of a property to its expected rental income.
For residential properties, the gross monthly income is typically used. For commercial and industrial properties, the gross annual income would be used.
The gross income multiplier method can be calculated as follows:
Sales Price ÷ Rental Income = Gross Income Multiplier
Recent sales and rental data from at least three similar properties can be used to establish an accurate GIM. The GIM can then be applied to the estimated fair market rental of the subject property to determine its market value, which can be calculated as follows:
Rental Income x GIM = Estimated Market Value
The present value of future benefits is a key component in many property valuations, particularly when it relates to income-producing commercial property.
The value of a commercial property depends in part on its ability to provide future benefits, such as rental income derived from a storefront. An estimate of the present value of those benefits is added to all of the other factors being evaluated, such as the building's square footage and location.
An appraisal is an opinion of the approximate market value of a property. A real estate agent might offer an appraisal, based on professional experience. It usually is offered for free to a prospective client.
A valuation is an analysis of the market value of a property, delivered in writing, usually for a fee.
Credentials required for an appraiser vary by state. Many states require a certain number of hours of experience and set minimum educational requirements for certification or licensing as a professional appraiser.
Accurate real estate valuation is important to mortgage lenders, investors, insurers and buyers, and sellers of real property. While appraisals are generally performed by skilled professionals, anyone involved in a real transaction benefits from a basic understanding of the different methods of real estate valuation.