Introduction

Understanding the value of a property is critical for making informed decisions in the real estate market. For buyers, it helps in negotiating a fair price, while sellers can use valuation to set a competitive selling price. Lenders also require property valuation to determine loan amounts.

This article provides an overview of how real estate values are calculated and case studies.

Methods of Real Estate Valuation

Real estate valuation involves a systematic approach to determine the fair market value of a property. Various methods are employed for this purpose, each suitable for different types of properties. This article will explain four major real estate valuation methods: the Sales Comparison Approach, the Income Capitalization Approach, the Cost Approach, and the Residual Development Approach.

Sales Comparison Approach

The Sales Comparison Approach (SCA), often referred to as the market approach, is a method used to estimate the value of a property by comparing it to similar properties that have recently been sold in the same area. It is commonly used for residential properties where enough comparable sales data is available.

Application

In applying the Sales Comparison Approach, appraisers typically look for comparable properties, often referred to as "comps", that have sold within the last six months to a year. These comps are then adjusted for differences in features such as size, age, location, and condition.

For example, if a comparable property sold for $300,000 but is larger than the subject property, an appraiser might adjust the price downward to account for the size difference. Conversely, if a comparable property has an outdated kitchen while the subject property has a newly renovated one, the appraiser might adjust the price upward.

Income Capitalization Approach

The Income Capitalization Approach (ICA), sometimes referred to as the income approach, is primarily used for valuing income-producing properties like apartment complexes or office buildings. This method focuses on the property’s ability to generate future income.

Application

ICA involves estimating the future net operating income (NOI) of the property and converting it to present value. This usually involves two steps: estimating the annual net income and determining the capitalization rate (cap rate), which reflects the rate of return an investor can expect on the property.

NOI is calculated by subtracting operating expenses from gross income. The cap rate is determined based on various factors including location, property type, and market conditions. The estimated value is obtained by dividing the NOI by the cap rate.

Cost Approach

The Cost Approach estimates the value of a property by calculating how much it would cost to build an equivalent property from scratch at current prices, and adjusting for depreciation. This method is particularly useful for new or special-purpose properties like churches or schools.

Application

The Cost Approach involves three steps:

1. Estimating the value of the land as if it were vacant.
2. Estimating the current cost to construct a replica of the property.
3. Estimating the amount of depreciation (physical and functional) and subtracting it from the cost.

Residual Development Approach

The Residual Development Approach is used for evaluating the value of a development site. It estimates what a developer might be willing to pay for the land, taking into account the end value of the development, less the costs of development and developer’s profit.

Application

To apply the Residual Development Approach:

1. Estimate the Gross Development Value (GDV) - the total sales value of the development once complete.
2. Deduct the Total Development Costs, including construction, professional fees, finance costs, and contingencies.
3. Deduct the developer’s required profit.

The residual value is what the developer may be willing to pay for the land.

Case Studies

I will show you case studies for each of the four real estate valuation methods.

Sales Comparison Approach

Background

Alice is considering buying a detached house in the suburbs of Tokyo. She wants to know the fair value of the property and hires a real estate appraiser, Bob.

Process

Bob, the appraiser, starts by gathering data on recent sales of comparable properties in the same neighborhood. He finds three houses sold in the last six months that are similar in size, age, and amenities.

• House A sold for $400,000 but is slightly smaller.
• House B sold for $450,000 and is almost identical.
• House C sold for $430,000 but has a larger yard.

Bob makes adjustments for these differences and estimates the value of the house Alice is considering.

Result

Based on the Sales Comparison Approach, Bob concludes that the fair market value of the house is approximately $440,000. Alice uses this information to make an informed decision about her purchase.

Income Capitalization Approach

Background

David is considering buying a small apartment building in Osaka for investment purposes. He wants to know if the asking price is justified based on the income the property can generate.

Process

David calculates the building’s net operating income (NOI) by subtracting annual operating expenses from the gross annual rent. He then determines a reasonable capitalization rate based on similar properties in the area.

NOI = Gross Annual Rent - Operating Expenses

He then uses the formula:

Property Value = NOI / Capitalization Rate

Result

David finds that based on the Income Capitalization Approach, the value of the property is slightly lower than the asking price. He decides to negotiate the price with the seller based on his findings.

Cost Approach

Background

Sara is considering purchasing a historical building in the center of a town to restore and operate as a cafe. The building has a unique value due to its historical significance.

Process

Sara hires a real estate appraiser, George. George calculates the cost to construct a replica of the building. He also evaluates the value of the land. Lastly, he estimates the depreciation due to the building's age and condition and subtracts it from the cost.

Result

George, based on the Cost Approach, estimates that the fair market value of the historical building is around $3 million. Sara uses this information to make an offer.

Residual Development Approach

Background

Michael is looking to purchase a large undeveloped plot of land near a major city for a residential development project.

Process

Michael hires Lisa, a real estate development expert. Lisa estimates the Gross Development Value by calculating the potential sales value of the developed residential units. She deducts all the costs associated with the development, including construction costs, professional fees, and the developer’s required profit.

Result

Based on the Residual Development Approach, Lisa estimates that the value of the land is around $5 million. Michael uses this information to negotiate the purchase price with the seller.