A real estate valuation is essential for property investors, home buyers, sellers, and others. Why is this the case? Because they ensure buyers don’t overpay, sellers are not undersold, lenders are provided with the information needed to approve loans, real estate court disputes are settled fairly, and much more. Also, although properties in an area may be similar, there are many factors that can set them apart financially, and that’s when a property valuation is needed to generate the true value of a piece of real estate.
Let’s dive into the rest of this article to learn more about the valuation of real estate where three methods are used to calculate a property’s worth – the cost approach, sales comparison approach, and the income capitalization approach.
Real Estate Valuation Definition
For those seeking an answer to the question, “What is valuation in real estate?” A real estate valuation, sometimes called an appraisal, is an assessment conducted on a piece of property through a specific method of calculation that determines its value.
A valuation such as this is typically performed by an experienced professional, and hired by someone who is in need of an accurate value appraisement of a personal, or investment home, as well as a commercial building. There are many elements that determine the value of a property, this can include location, renovations, the size of the lot the property rests on, economic trends, as well as a variety of other factors. When the valuation is completed, a formal report is typically generated.
Reasons Why Real Estate Property Valuations are Needed?
An official valuation can be requested for various reasons – from investment purchasing decisions to business and legal matters to financial requirements. Additionally, different property types often need a valuation. This would include residential personal property and residential rental real estate, and there are those who may need a commercial real estate valuation too.
Here are just a few reasons why a personal home or investment property would be in need of a real estate valuation:
Residential Personal Property (Personal Home):
- Valuations are used to assist real estate agents and homeowners in determining selling or buying prices.
- They’re often used by insurance agents to establish the price to rebuild, set prices for adequate homeowners insurance coverage, and to settle disputes when the homeowner does not agree with the loss settlement.
- House valuations are used to determine or attempt to lower gift inheritance taxes.
- Used often by underwriters to settle on a value of security for home mortgage loans.
- A real estate property valuation is often needed in court disputes during divorce proceedings, eminent domain cases, and more.
Residential Rental Property & Commercial Property
- To estimate the value of a potential rental property to assess if it’s a worthy investment piece.
- To determine the market value of a forced sale or property sold at an auction.
- Used for insurance-related purposes to ensure proper coverage is received, especially with tenants in place.
- A real estate appraiser may be needed to establish an investor’s portfolio worth.
- Needed by banks who are providing a refinance or original loan to investors or business owners.
How Do You Calculate the Value of a Property?
Since there are various property types and many reasons for needing a valuation, it’s not always helpful to just rely on a quick residential real estate valuation calculator found online. And as you can imagine, a commercial real estate valuation calculator wouldn’t be recommended either when there is so much at stake with high-cost commercial buildings. The bottom line is that there are too many factors that need to be taken into consideration that a universal calculator wouldn’t be able to pick up on. This is why different valuation methods exist for calculating a property’s worth and why a one-size-fits-all “calculator” is just used as a rough estimate.
Three commonly used methods for determining the value of a piece of real estate are the cost approach, the sales comparison approach, and the income capitalization approach. Now, you won’t have to take a real estate valuation course to understand the basics of these methods, it’s really not too difficult. With that said, let’s dive in to learn more about each property valuation technique and how they are used to calculate value:
1. Cost Approach
This valuation method for real estate factors in three elements – what the land is valued at, the cost to construct an equivalent building, and depreciation. The formula is as follows:
Property Value = Replacement Building Construction Costs – Depreciation + Land Value
Breaking the cost approach down into simple steps:
- Step 1: Appraise the current value of the land as if it were vacant.
- Step 2: Determine the price of constructing a new comparable building.
- Step 3: Estimate the amount of depreciation of the current building.
- Step 4: Minus the real estate depreciation from the construction costs.
- Step 5: Add the current land value to the depreciated cost of the piece of real estate.
Why is the Cost Approach Used for Home Valuations?
This particular real estate valuation method is useful when there are not enough comparable sales/properties in the area. The cost approach is also utilized for unique properties, newly built properties, and proposed construction projects. It can also be helpful for insurance purposes to determine the value of a property, if it were to be destroyed by a fire in the future.
2. Sales Comparison Approach
The sales comparison approach, which is also referred to as the market approach, is a real estate valuation method that calculates a property’s worth by comparing similar properties that have recently sold, or newly listed properties. It relies heavily on current market data that can be pulled from various real estate valuation websites for a quick estimate. Three to four property comparisons are recommended to come up with a good price range.
The properties should be as similar as possible, have been recently sold, preferably no longer than a year ago, and should have also been sold with market conditions that are typical – nothing out of the ordinary that makes it a unique sale.
What Elements are Normally Considered When Appraising a Home Using the Sales Comparison Approach?
Since no two homes are typically exactly alike, when viewing comparable properties, certain elements should be taken into consideration:
- The size of the lot the property sits on.
- The location since neighborhood prices may vary.
- Zoning laws in the neighborhood.
- Age of the properties.
- Total square footage and the number of bedrooms.
- Amenities such as a pool, upgrades done to the kitchen, windows, HVAC system, and so on.
The sales comparison approach is normally used by property investors, real estate brokers and agents, and the like. A similar method is used when determining rent comparables when investors are calculating the market rent. If you’re interested, you can learn more about this in my latest article on Maximizing Rental Income: Understanding Rent Comparables and Gross Rent Multiplier.
3. Income Capitalization Approach
Often just referred to as the income approach, this method allows for the estimation of the value of a piece of real estate based on the income that it will generate. This is accomplished by dividing the net operating income (NOI) by the capitalization rate (cap rate).
Net Operating Income ÷ Capitalization Rate = Property Value
For those of you who are unfamiliar with net operating income and capitalization rates, it might be difficult to complete the above formula. With that said, let’s look more into these two items so you have a better understanding:
What is Net Operating Income (NOI)?
The NOI is the income remaining after all operating expenses (maintenance, insurance, property management fees, and the like) have been subtracted, as well as other items that reduce the overall income. As an example, let’s say a rental property has an income of $100,000 a year and $70,000 in operating expenses – the net operating income, in this case, would be $30,000.
What is a Capitalization Rate (Cap Rate)?
The cap rate is used to determine an estimated rate of return that an investment property will generate. It can be calculated by taking the NOI and dividing it by the current market value of the property.
Cap Rate = Net Operating Income ÷ Current Market Value of Property
A higher cap rate is generally what an investor is looking for when evaluating a potential property.
Let’s break the income approach down with this simple example:
- Step 1: Investor calculates a net operating income of $40,000.
- Step 2: The cap rate is then calculated and comes to 0.062.
- Step 3: Investor divides the NOI of $40,000 by the cap rate of 0.062.
- Step 4: The income approach yields a final property value of $645,161.
Keep in mind that the income approach doesn’t focus on the condition of the building, or expenses that may unexpectedly come up in the future, and so on. This means that an investor may have to do some additional research to determine if a property is going to be truly profitable or not.
Why is the Income Approach Used to Find Property Values?
The income approach is mostly used for income-generating properties such as residential rental real estate, but it’s also used in commercial real estate valuation methods, and it’s often needed by bank lenders for various reasons.
It’s worth noting that if you’re seeking out a real estate valuation company, make sure they offer all three valuation methods, so you know they are capable of handling jobs of all sizes and complexities.
Real Estate Valuation Commonly Asked Questions
As someone who is interested in valuation real estate methods, you most likely have many questions. That said, below you will find three of our top questions that may interest you:
1. What is the Market Value of Real Estate?
It’s an estimated value of a property’s worth based on what home buyers might pay when considering the current competitive market in regards to what other properties are selling for in a particular location – it’s closely related to the supply and demand factor.
What can affect the real estate market value of an area? The answer is existing home sales, crime rate, population growth, the job market of the area, vacancy or foreclosure rates, and more. Assessing property by market evaluations alone typically does not provide the detailed real estate valuation report that is often needed, and this is why it’s so important to determine the value through a reliable standard valuation method.
2. Does a Fannie Mae Loan Require an Appraisal?
If you’re trying to obtain a loan through Fannie Mae, know that they typically require the real estate valuation metrics that would be found in a final valuation report. This report is needed for the underwriting decision-making process. In some cases, Fannie Mae will waive the appraisal process, but only under certain conditions. You can view the Fannie Mae Appraisal Waivers Fact Sheet for more information.
3. Will Digital Valuations Replace Traditional Real Estate Valuation Services?
Although we can’t say for sure that the traditional valuation model will be replaced by advanced real estate valuation software and other technology, we do know that some companies are transitioning towards that goal. They see a need for a valuation method that offers the same perspective and appraisal methods for each property. Although the transition is wanted by many, the more real estate valuation jobs that are replaced by digital methods could put many people in the industry out of work.
You see, the valuation of real estate is complicated by the fact that today’s method of valuation can vary greatly from appraiser to appraiser, which can generate different home values for the same property. Because of this, and the goal of attempting to streamline the process so it’s quicker and more cost-effective, digital appraisals are on the rise with advanced computer algorithms that contain accurate market insights, property characteristics, the usage of drones, and other digital technologies.
At this time, at most, appraisal companies may be doing a hybrid real estate valuation – part digital and part manual. Forbes dives into this topic in their article – The Residential Appraisal Process Needs A New Standard.
Additional Morris Invest Real Estate Articles
Since you’re here today researching the real estate valuation model, then you must be interested in real estate in general. That said, you’ll want to dive into the following article we put together that provides a wealth of knowledge on investing in turnkey properties, as well as this post that covers the essential role property managers play, and as the following posts:
- What is landlord insurance and why should you have it?
- Is a cost segregation study worth it? Find the answer here.
- Buy financially out-of-reach properties with multiple investors.
- Learn why a turnkey property is a good investment.
- Learn all about estate planning and why it’s so important.
- Rental income and taxes – What you need to know!
- Which is the better investment – stocks or real estate?
- See the role equity plays in your real estate portfolio.
- Texas real estate is less expensive making it ideal for investors.
Use Real Estate Valuation Methods for Generating Accurate Property Assessments
The three valuation methods discussed are the most commonly used in establishing accurate property values, so if you’re seeking information on different methods for appraising a property’s worth, we hope that one of the above methods works for you and your specific situation. Also, if you’re new to the game, a good real estate valuation analyst should be able to set you on the right path as to which method is right for you.
For those who are real estate investors currently looking for a turnkey property, our full-service investment company can provide you with a cash flowing rental house where all the details are taken care of for you, from start to finish – from finding a lucrative rental market to placing a tenant for you. Feel free to schedule a complimentary call to speak with someone from Morris Invest about what we can do to help you reach your investing goals.
Take a moment to watch this quick video that touches on why you should never buy a property that’s selling for above the appraised value:
