Understanding Real Estate Valuation Models

Introduction

 

The real estate sector is an important part of a country’s economy. The growth, development, and flow of investment in a country can largely depend on the accurate and transparent valuation of real estate. In some cases, accurate property valuation has also led to a boom in the country’s real estate sector (deJong). But even on an individual level, real estate valuation is required for many purposes such as determining payments on rent, tax, insurance, maintenance, and loans (Chan). Without a proper real estate valuation model, it can become exceedingly difficult to carry out basic property related tasks without chances of loss or fraud. Speculation on part of real estate agents and brokers can also artificially inflate or deflate a property’s value. Therefore, it is important to understand what models are used while determining the value of the real estate. Continue reading to get deeper insights into how real property is valued.

 

Research Questions

1. Why is Real Estate Valuation carried out?
2. What are the methods of Real Estate Valuation?

 

Why Real Estate Valuation is Carried Out

 

Before diving into how real estate is valued, the significance of the exercise must be understood. Real estate valuation, or commonly known as property valuation, is not required only in the buying and selling process, rather, it is essential for realising the potential of an area, carrying out loan assessments, optimising local taxes, calculating depreciation, and maintaining investment portfolios. One particularly important use case for real estate valuation is in the shared space market. Apartments and commercial properties are usually bought in shareable parts of larger buildings. If a proper valuation is not carried out, it can lead to the exploitation of one party over the other (Pwc, 2021). Real estate markets are also vital to growth in the construction and development sector. Having appropriate investment and valuation strategies that account for a building’s technical and structural attributes can be a critical success factor for many companies (Hossein Toosi, 2020). Besides these important applications, a variety of endeavours including financing, sales listings, investment analysis, property insurance, and taxation also use property valuation. Valuing real estate can be a difficult task as each property is unique in its size, location, curb appeal, design, and availability of local infrastructure.

It is very easy to equate real estate value with the cost or price of the property. In reality, both are separate concept. It can be that the cost of purchasing a home is very high, but due to faulty foundations, the value remains low. Appraisals are used to calculate the value of real estate at any given point in time. Unlike consumer goods, the benefits of owning a real property can be realised over a long period of time. Therefore, the valuation must also consider the economic and social factors. The demand, utility, transferability, and scarcity of a property play a large role in its overall valuation. Demand is the desire for ownership that can be satisfied by financial means. The ability to satisfy a consumer’s need is known as utility. In case of a high demand, scarcity will add to a property’s value manifolds. Almost 60 to 70 percent of cases in Pakistani courts are related to land transfer and ownership issues (UK Home Office, 2017). Transferability is also a key aspect when it comes to the valuation of real estate (Folger, 2020).

 

Methods of Real Estate Valuation

 

Three techniques are widely used to conduct appraisals for calculating real estate value namely, the comparable sales approach, the income approach, and the cost approach. In the comparable sales approach, the property is compared to recently sold properties that are similar in characteristics. The comparable property must be sold within a year and must also have been sold in typical market conditions. The size and location of the comparable can also have a significant impact on the property’s valuation. Adjustments can be made to a comparable’s price depending on factors like age, condition of a building, terms of sale, location, and physical features. It is better to compare the property being valued with at least two to three different properties. The final average will determine the value, although more consideration will be given to the comparable with the least amount of adjustment.

The cost approach method for valuation estimates the value of a property according to what the cost of building an equivalent building would be. In this approach, the total value of the land is equal to the cost of land plus the total cost of construction, less the depreciation. The method is widely used for properties that are new and is fairly accurate in determining the value (Liberto, 2021). The income approach model estimates the value of a property based on the income it can generate for the investor. The value is calculated by taking the net operating income and dividing it by the capitalisation rate (Hargrave, 2020). The method is similar to discounted cash flow as in finance. In this approach, the investor uses the amount of income generated along with other factors to determine how much the property is worth in the market. The investor should also consider how efficient the property is. For example, if there are repairs needed, the value will drop. All in all, the three approaches mentioned above are primarily what is followed for the valuation of properties.

 

Conclusion

 

An accurate valuation of real estate can lead to a boom in Pakistan’s real estate sector. Many areas like financing, sales listings, investment analysis, property insurance, and taxation use property valuation. However, estimations for real estate value are difficult to make since each property is unique in size, location, and design. The three methods of comparison, cost, and income provide a strong basis for real estate valuation. Therefore, using these methods efficiently can provide an accurate and transparent analysis of real estate value.