Real Estate Valuation Methodogy

Once the highest and best use for real estate is established, the various methodologies for valuing improved property can be utilized.

The easiest method to understand is the sales comparison approach a/k/a the comparable sales approach. In this method, value is established by analyzing sales, listings or pending sales of properties that are similar to the subject property.

In the sales comparison approach, an opinion of value is developed by comparing properties similar to the subject property that have recently sold, are listed for sale or are under contract. Obviously, the highest and best use of a property is relevant because the sales comparison method works best when the properties being compared have the same or similar highest and best uses.

The sales comparison approach is applicable to all types of transactions when there are sufficient, recent, reliable transactions to indicate value patterns or trends in the market. This, however, is predicated upon the existence of a market. If, for example, a piece of property has a court building constructed on it there may be no market for its sale; the market would be for the vacant land, utilized in another fashion, less demolition costs. Therefore, the sales comparison approach works best for owner-occupied properties not for properties that are purchased for their income producing qualities.

The next method for appraising improvements is the cost approach. This involves the theoretical breakdown of property into land and building components. It is theoretical because buyers purchase rights not land and buildings. This creates issues that are not applicable in the sales comparison approach or the income approach. As an example, external obsolescence is an issue for the cost approach but not for the sales comparison or income approaches.

In the cost approach an analysis is performed of the cost of the improvements by comparison to the costs to develop similar improvements as evidenced by the cost of construction of substitute properties with the same utility as the subject property. The estimate of development cost is adjusted for losses in value caused by age, condition, utility and location. Then the value of the land (assessed by other methods not discussed herein) is added.

The cost approach is an analysis of the market’s perception of the difference between the property being valued and a newly constructed building with optimal utility. The appraiser must consistently distinguish between two costs bases: reproduction costs (an exact replica of the property) or replacement costs (a property of similar size and utility).

The costs to construct the existing structure and site improvements (including hard costs, soft costs and entrepreneurial profit) use three techniques: (1) comparative unit method; (2) unit in place method; or (3) quantity survey method.

The comparative unit method is used to derive a cost estimate in terms of dollars per unit or area or volume based on known cots of similar structures that are adjusted for time and physical differences usually applied to the total building site. Contract prices are usually employed to determine the comparative unit method, i.e. $20/s.f. In the absence of contract prices the total cost of a building can be extracted from sales of similar building as long as the following are met: (1) the improvements reflect the highest and best use of the property; (2) the property has reached stabilization; (3) supply and demand are in balance; and (4) the site value can be reasonably ascertained.

The unit in place method a/k/a segregated cost method arrives at the cost of a property by adding together the unit costs for the various building components as installed, i.e. excavation, foundation, etc.

The quantity survey method is the most comprehensive and accurate method of cost estimating. A quantity survey reflects the quantity and quality of all materials used in the construction of improvement and all categories of labor required. Then contingencies are added for overhead and profit.

From the costs are deducted all depreciation in the property improvements as of the valuation date. Depreciation is established by one or more of the following: (1) market extraction method; (2) economic age-life method; or (3) breakdown methods.

The market extraction method relies on the availability of comparable sales from which depreciation can be extracted.

The economic age-life method is a ratio of the effective age of the property in comparison to its expected economic life and then applying this ratio to the property’s costs. The formula is (Effective Age/Total Economic Life) x Total Cost = Depreciation.

The breakdown method is the most comprehensive and detailed way to measure depreciation because it differentiates depreciation into its component parts: (1) physical deterioration; (2) functional obsolescence; and (3) external obsolescence.

Functional obsolescence is relevant when a property lacks something that other properties have in the market such as air conditioning or elevators. There is also something known as a super-adequacy which is a type of functional obsolescence caused by something in the property that exceeds market requirements but does not contribute an amount equal to its cost. As a simple example, imagine a pool being installed in a residence for $25,000.00. The pool may not increase the value of the house by $25,000.00 and may decrease the value of the house because many owners don’t want to assume the liability imposed by a pool.

External obsolescence is a loss in value caused by an external factor such as an over-supplied market, proximity to an environmental disaster, being located in a neighborhood that would not encourage use of the property, etc.

When the value of the land is added to the cost of the improvements less depreciation the result is the value of the fee simple interest in the real estate.

The third method for valuing real estate is the income capitalization approach. An investor who purchases income-producing property is essentially trading current dollars in expectation of receiving future dollars. The income approach is used to analyze a property’s capacity to generate monetary benefits of income and reversion into an indication of present value.

There are two principle methods for employing the income capitalization approach: (1) direct capitalization and (2) yield capitalization.

Direct capitalization is a method used to convert an estimate of a single year’s income expectancy into an indication of value in one direct step, either by dividing the net income estimate by an appropriate capitalization rate or by multiplying the income estimate by an appropriate factor.

Yield capitalization is used to convert future benefits, i.e. an income stream, and reverting same into present value by discounting each future benefit at an appropriate yield rate or by applying an overall rate that reflects the investment’s income pattern, change in value and yield rate.

The purpose of this article is simply to provide you with an outline of the appraisal process; it is not intended as a detailed treatise on the appraisal process although it may seem like same.