What Are The Principles of Real Estate Valuation
There are several reasons why a property’s value may need to be determined. These reasons may range from the sale or transfer of ownership to the purchase of sufficient insurance.
But how exactly is real estate value determined to as high a degree of accuracy as possible around the world?
A range of different practical techniques and processes may be applied to the property valuation depending on the location of the building or land in question and the background of the firm undertaking the survey.
However, despite some variation in terminology, most organizations use a similar set of approaches.
This article explores the critical fundamentals of global real estate valuation, from the primary indicators of a property’s financial worth to popular methods used by most surveyors to distill the information available into precise, detailed figures.
Fundamental Indicators of Real Estate Value
The leading indicators used to determine the value of an item of real estate are:
Below, we will go into detail to define these terms and explain why they are fundamental to determining property value.
If the market reveals a clear and demonstrable growing “demand” for a particular type of property, its value is very likely to increase.
“Demand” can be defined as a need for ownership or use, influenced either by necessity or desire.
As long as the demand for a particular type of property originates from a demographic with the financial means to purchase that type of desired real estate, its value will continue to rise.
“Scarcity” means relatively low levels of availability. If a specific type of desired property is rarely available, potential buyers will likely be willing to pay more in order to secure it for themselves. In this way, scarcity drives up property value.
The combination of demand and scarcity is a common reason for significant price rises in the property market.
If a property’s ownership can be easily transferred from one individual or organization to another, it will likely command a higher value.
This is because the transaction may be considered relatively low-risk – and will not require the application of large amounts of time and effort. It usually means less paperwork and a lower likelihood of legal disputes further down the line.
Prospective buyers are often willing to spend more for greater levels of ease. In order to research transferability, a title search is performed by checking on the legal history of a property.
Perhaps the most straightforward of all value indicators, the term “utility” refers to the degree to which a particular property can fulfill all of a potential buyer’s requirements and preferences.
In terms of a residential property, this may include everything from proximity to specific amenities to the number of rooms or the existence of a good-sized outdoor space.
Popular Valuation Methods
There are many valuation methods that are commonly utilized worldwide to generate verifiable “real world” figures. These include:
- Comparable Method
- Profit Method
- Investment Method
- Residual Method
- Cost Method
Below, we will detail what these methods involve and how they are used to determine value.
One of the most common techniques used in property valuations, for example, is to research the prices of similar buildings or areas of land that have recently been sold in the same neighborhood as the real estate item in question.
It is best to apply this method to a property that can easily be compared against others – for example, it is located on an estate of similar houses built simultaneously.
The chosen real estate items must be as close in design and style as possible to make the comparison fair.
In the case of a residential property, surveyors must seek out other homes as close by as possible, with the same number of bedrooms, reception rooms, and bathrooms and the same size and quality of outdoor space.
All compared properties should be in a similar state of repair.
Consideration should be given to the behavior of the real estate market at the time the other properties were sold, as well as the age and quality of any decor and furnishings and any other features that may make a property more or less valuable than the chosen comparisons.
All of this research is a part of the appraisal process.
The “profit method” is most commonly applied to commercial property and involves calculating the capacity of the building in question to make a profit. Because of this, the approach is usually best employed when valuing properties that already have businesses in situ.
Generally speaking, the commercial properties best served via the profit method tend to be restaurants, hotels, and buildings within similar sectors.
The investment approach has some similarities to the profit method and can be applied to both domestic and commercial freehold/leasehold properties. It involves determining the potential for the building or land in question to generate a return on investment in the future.
Because of this, it is employed to best effect where a building has tenants that provide a rental income to its owner.
This technique involves valuating a property based on its potential rather than its existing features.
The residual method can ascertain the value of buildings or land.
It involves calculating a property’s “gross development value” – i.e., the projected revenue amount that will be generated via the sale or other application of the project once it is finished. The surveyor will then subtract the costs involved in the development itself.
The amount leftover is considered the “residual” sum.
There are many changeable factors that go into the development of a property, which means it can be difficult to accurately calculate the project’s total cost before it is completed. For this reason, the residual method can be somewhat risky.
Under certain circumstances, the cost method is considered one of the most practical ways to determine real estate value.
This approach, sometimes called the “contractor’s method,” involves calculating as accurately as possible the amount it would cost to recreate the property from scratch in the current market.
This method is often used for unique properties where it is difficult to gauge demand or find any comparable property from which to glean an approximate guide figure.
Any value generated via this method should consider the property’s age and any other factors or features that could potentially push an asking price up or down.
While “Utility” remains the core value indicator for many real estate items, there are numerous other aspects that can – and do – affect the final estimated asking price.
The more unique a building is, and the more specific its applications, the more likely it will require complex and sophisticated valuation techniques to determine its worth to potential investors or buyers.
Precision is vital for real estate valuation. Each generated figure can mean the difference between profit and loss or the capacity for insurance to suitably cover all aspects of a property without falling short.
For this reason, surveyors often apply a combination of the above valuation techniques in order to settle on a final figure that is as accurate as possible.
When purchasing property, the appraisal will be one of the costs borne by the home buyer.
An appraisal is a part of most real estate transactions, whether buying a property abroad or in the United States. Whether you are buying or selling a home, it makes sense to understand the basics when it comes to valuation.
About the author: The above article on real estate valuation was written by James Durr. James has been a property buyer and developer for almost 2 decades.
As one of the co-founders of a leading UK home buying firm, he has accumulated a vast amount of knowledge in speaking effectively and empathetically with property owners and business owners to find genuine win-win solutions.