Property Valuation Methodology

Introduction

Sellers base their asking price on the valuation, while property buyers need to decide whether a certain real estate is worth its price and, if not, how much to offer for it. A valuation is not simply your estate agent telling you a couple of similar houses down the road are on sale for £x. Appraising the value of a property is a complex matter where many factors have to be taken into account - it is a combination of art and science.

Estate Agents & Property Valuation

It is a common misconception that estate agents value your property for you. Agents simply guide you to a suggested asking price and do not claim to offer an objective and accurate valuation. Independent property valuations are performed by chartered surveyors.

It is important to be aware that not all estate agents have your best interests at heart. The initial asking price an estate agent recommends might be over-inflated because of the desire to win a sale instruction. On the other hand some estate agents may encourage a seller to accept a below-market offer in order to secure a quick sale. Despite being paid a percentage-based commission, estate agents may make more money by turning over properties quickly at a lower price than holding out for a higher price and having properties sitting on the books.

DIY Home Valuation

It is perfectly possible for non-professionals to conduct their own valuation and gain a solid understanding of their property's worth.

Unfortunately, a thorough understanding of valuation theory and methodology is not commonplace. There has been little comprehensive literature available as to what constitutes value and of the different methods of determining house worth. The following article will provide some insight into theoretical approaches to value and valuation methodology.

There are two main theoretical approaches to determining the value of a house, namely the Comparable Sales Method and the Income Sales Method Approach. A third method, the Cost Approach, will be discussed briefly, but since it is not an autonomous approach, emphasis will be put on the first two methods. The first valuation method focuses on actual market data, whereas the second calculates the profitability of the investment. Since the two approaches complement each other, a carefully conducted valuation should always use both.

Value

Value is, of course, a subjective rather than an objective term. A property might be more valuable to one person than to another, because different people may derive different utility from the same property. The forces influencing the value of a property include its environmental and physical characteristics, social standards, economic influences and political or government regulations.

The valuation methods discussed below are theoretical approaches to the question of value and help estimate the worth of a property to a buyer or seller. In practice, however, it is the free market, i.e. the forces of supply and demand, which decide what amount of money a house changes hands for.

There may be a substantial gap between subjective valuations and the fluctuations of the free market. Thus, the value of a property does not always correspond to its price. The forces of supply and demand cannot be predicted reliably. Every property valuation can only ever be a guideline to what the house might change hands for.

The Comparable Sales Method

The "Comparable Sales Method" is sometimes called the "Inferred Analysis" method of property valuation. This method estimates the value of a house by comparing it to the prices of similar properties sold in similar locations within a recent period of time. The basic assumption is therefore that a property is worth what it will sell for, in the absence of undue stress and if reasonable time is given. This method works with the market value of homes. It is the most prevalent method in the residential property market, concerning general trends and projections and employing the principle of substitution.

Procedure

1. The central task is to systematically assemble data on comparable properties. Basically, the forces influencing value have to be weighed against each other. The relevant elements to look for can be split into transaction and asset characteristics:

• Transaction Characteristics - Date of transaction, means of payment, transaction speed, etc.
• Asset Characteristics - Size, location, conditions, utility, building regulations, business climate, etc.

2. The best way to compare property would obviously be to inspect it in person. Since this option is very time-consuming and not always possible, the next best solution is to search property transaction databases. An ideal database will contain information relating to transaction date, price paid, property features and size etc.

3. Once the data has been obtained and collated the task is to draw informed conclusions on the value of your property - for example a valuation price range - based on the evidence collected. Obviously those properties that are most similar to yours should receive a greater weighting than those which are less comparable.

Advantages

• It is the most easy and straightforward method and has become general practice in the residential housing market
• It leads to an objective valuation being placed on the property. The answer is connected to the actual market value as opposed to an individual's preferences

Disadvantages

• Sometimes it might be difficult to locate enough similar property transactions to draw meaningful conclusions with regards to what the value should be
• Market value and price might differ due to "unreasonable" actions by other actors
• This technique makes no reference to intrinsic value. If a property's price is reasonable on a comparable basis, it does not necessarily follow that this is a reasonable buying or selling price for an individual. For example, I might want to purchase a property in order to let it. The property's price might be within a reasonable market price range, but because average rents in the area are not very high, the investment would not be profitable to me

The Income Method

The "Income Method" is also termed the fundamental, or intrinsic method of property valuation. In this method, the present worth of a property is estimated on the grounds of projected future net income (in rent, for example) and re-sale value.

The method uses the discounted cash flow (DCF) model to determine the present value of an investment. One underlying assumption of this approach is the principle of opportunity cost of capital, i.e. that money is of more value to its holder today than in the future. The principle of anticipation is fundamental to this approach. It states that value can be created today by expected future profits.

Although slightly complicated, this method is an essential element to the valuation of any property; it is almost always employed by financial and investment professionals when valuing assets.

Procedure

1. This method relies on making certain key assumptions - both the prospective income generated by the property and resale value have to be estimated. This appraisal is based on the principle of highest and best use and on comparable data.

2. In order to calculate the present value of a property, prospective future income has to be discounted to reflect the cost of equity capital. This is part of the discounted cash flow (DCF). The opportunity cost of capital can be interpreted as the income that would otherwise have been generated had the capital been invested in an asset of similar risk instead.

3. The difficult part in calculating the DCF is how to estimate the risk involved. In property dealings, these estimates are usually based upon historical data on house price volatility. This volatility is broadly in line with the general market volatility, and our 8% example as the cost of equity capital can be safely justified.

4. The next step involves calculating the present value (PV) of the property based on selling it for 50% more in ten years' time. The way to calculate present value (PV) is to divide the future value of a house by the discount rate plus one to the power of the number of years.

5. In recognition of the fact that the property will also generate income over the next ten years we need to calculate the present value of this income stream and add it to the value calculated above. A buy-to-let property produces a constant income stream in the form of rent, but this concept can also be applied to owner-occupied properties. Simply imagine the owner is paying themselves the market rate in rent.

Advantages

• It focuses directly on the value of the property to the individual concerned
• Income analyses are very detailed and derive specific conclusions (in contrast to the more general approach practised in the Comparable Sales Method)

Disadvantages

• This method is more complex and less intuitive than the Comparable Sales Method. This is one of the reasons why it is often overlooked
• This method ignores the actual market prices for property by neglecting the comparable sales analysis
• The ultimate house price recommendation is highly sensitive to the assumptions made

The Cost Approach

The Cost Approach estimates the replacement value of a property by analysing the cost of its components, i.e. land and building. It lies somewhere between the inferred and the intrinsic methods, and is not a fully autonomous valuation method.

Value is calculated by adding the free market value of the land as if vacant to the reconstruction cost of the building, minus depreciation suffered over the years in comparison to a new building.

Procedure

1. Estimate the value of the land as if vacant, by comparing it to similar properties
2. Estimate the replacement cost of the building at present. Factors to be considered include site preparation, utilities, types of building improvements, tenant improvements, and soft costs
3. Assess the depreciation that has occurred to the building and deduct the figure from the replacement cost of the building
4. Add the estimated worth of the land, and the resulting figure will be an indication of the value of the property

Advantages and Disadvantages

This method sets the value at the actual cost or price of the property, however it relies upon other valuation methods to derive the value of the land. Furthermore, it neglects the difference between cost and value, namely that one property might be cheaper than another but generate a much higher net income.

Summary and Conclusion

Summary of the Methods

The Comparable Sales Method focuses on market data of sales of similar property in a recent time period and thus gives an indication of current market value for a particular kind of property. Sales comparisons can easily be performed using data found online and by conducting individual research. The advantage is that it reflects the actual market prices, but it neglects whether or not the market value corresponds to the value attached to the property by either the seller or the buyer.

The Income Method concentrates on the intrinsic value of a property purchase. It analyses the present worth of projected future net income and re-sale value. This method gives a good appraisal of whether a certain property is worth its price to an individual, but it does not indicate the market value of the property.

The Cost Approach lies somewhere between the two previous methods and is not actually an autonomous technique of value analysis. It estimates property value by adding the cost of the land to the replacement cost of the building minus depreciation, thus coming up with a figure of how much the property should be worth.

In order to obtain a good estimate of value for a property it is necessary to employ both the sales-comparison and income methods.

Conclusion

There is no perfect method of assessing the value of a property. Appraisal is an art as much as a science, and in the end it is supply and demand which determine the actual selling price of a house.

Nevertheless, the methods discussed above provide guidelines to both buyers and sellers on how to estimate the approximate worth of a house. This helps sellers decide where to set the price for their property and provides buyers with means of deciding whether a particular property purchase is sensible.