Figuring out the value of real estate is important for many things like getting a loan, selling, investing, getting insurance, and taxes. However, for most folks, it’s most helpful when deciding how much to ask for or pay when buying or selling a property. This article will give you a basic understanding of real estate valuation, especially in the context of sales.
In simple terms, a property’s value is the money it’s worth based on what you’ll get from owning it in the future. Unlike things we use up quickly, like groceries, the value of property grows over a long time. So, when we figure out how much a property is worth, we have to think about things like economic trends, social changes, rules set by the government, and environmental factors. These things affect four important parts of value:
- Demand: This means how much people want to own the property and if they can afford it.
- Utility: It’s about how well the property can meet the needs and desires of future owners.
- Scarcity: This talks about how there’s a limited number of similar properties to compete with.
- Transferability: It’s how easy it is to transfer ownership rights to someone else.
Value isn’t always the same as cost or price. Cost is what you spend on things like materials and labor. Price is what someone pays for something. While cost and price can influence value, they don’t decide it. For example, a house may sell for 50 lacs, but its actual value could be more or less. If the new owner discovers a big problem, like a damaged foundation, the house’s value could be less than the price.
An appraisal is when someone gives their opinion or estimate about how much a property is worth on a certain date. Businesses, government groups, regular folks, investors, and mortgage companies use these reports when they’re dealing with real estate. The main aim of an appraisal is to figure out a property’s market value, which is the most likely price it would sell for in a fair and open market.
The price a property sells for, known as the market price, doesn’t always show its true market value. For instance, if a seller is in a tough spot, like facing foreclosure, or if it’s a private sale, the property might sell for less than it’s worth.
Getting a precise appraisal relies on carefully gathering information. This includes specific details about the property itself and more general information about the country, area, city, and neighborhood where the property is found. Appraisals use three main methods to figure out how much a property is worth.
The sales comparison approach is often used to figure out the value of single-family homes and land. It’s also called the market data approach. This method estimates the value by looking at properties that have recently been sold and are similar to the ones you’re trying to value. These similar properties are called “comparables.” To make a fair comparison, these comparables should be as much like the property you’re valuing as possible. They should have been sold within the last year in a competitive market and under normal market conditions.
In the appraisal process, it’s a good idea to use at least three or four comparables. When choosing comparables, the most crucial things to think about are the size, similar features, and especially the location. The location can impact how much a property is worth.
Qualities of Comparables
Because no two properties are the same, we make adjustments to the sales prices of comparables to account for differences in features and other factors that affect the value. These factors include:
- Age and Condition of Buildings: We look at how old the buildings are and what condition they’re in.
- Sale Date: We also check if there were any economic changes between the sale date of a comparable property and the date of the appraisal.
- Terms and Conditions of Sale: This includes whether the seller was in a tough spot or if the property was sold between family members at a lower price.
- Location: The neighborhood where the property is located matters because prices can vary from one area to another.
- Physical Features: We consider things like the size of the lot, landscaping, the type and quality of construction, the number and type of rooms, square footage, and special features like hardwood floors, a garage, kitchen upgrades, a fireplace, a pool, or central air.
The value we estimate for the property will fall within the range formed by adjusting the sale prices of the comparables. Some adjustments are more subjective than others, so we give more weight to the comparables that need fewer adjustments.
The cost approach is used to figure out the value of properties that have one or more buildings on them. With this method, we estimate the value of the building(s) and the land separately while considering any wear and tear (depreciation). Then, we add these estimates together to find the total value of the whole property with the improvements.
This approach works on the idea that a sensible buyer wouldn’t pay more for an existing improved property than what it would cost to buy a similar piece of land and build a similar building on it. It’s helpful when the property being appraised is not commonly sold and doesn’t make money, like schools, churches, hospitals, and government buildings.
We can estimate building costs in a few ways:
- Square-Foot Method: This method looks at how much it costs to build one square foot of a similar building and then multiplies that by the number of square feet in the building we’re interested in.
- Unit-in-Place Method: Here, we estimate costs by looking at how much it costs to build each part of the building, like walls, floors, and roofs, including both labor and materials.
- Quantity-Survey Method: With this method, we figure out how much of each raw material is needed to rebuild the building, along with the current prices of those materials and the cost of putting them in place.
These methods help us estimate the cost of constructing or replacing a building.
When we appraise a property, we look at something called depreciation, which means anything that makes a building on the property less valuable. This includes:
- Physical Wear and Tear: This can be stuff that can be fixed, like a paint job or a new roof, or things that can’t be easily fixed, like structural problems.
- Functional Issues: These are things that used to be popular but aren’t anymore, like old appliances or a house with lots of bedrooms but only one bathroom.
- External Factors: Sometimes, the value can go down because of things outside the property, like being too close to a noisy airport or a factory that’s polluting.
Here’s how we figure out the property’s value:
- Calculate the Land Value: First, we determine how much the land is worth as if nothing was built on it. We use the sales comparison approach for this because land doesn’t lose value over time.
- Find the Building and Improvement Costs: We figure out how much it would cost to build the building(s) and make any improvements on the property right now.
- Calculate Depreciation: We consider how much the building(s) has lost value because of things like wear and tear, outdated features, or external factors.
- Subtract Depreciation: We take away the depreciation from the estimated building and improvement costs.
- Add Land Value: Finally, we add the value of the land to the cost of the building(s) and improvements with depreciation to get the total property value.
This method often called the income approach, looks at how much money a property makes compared to the return an investor wants. We use this to figure out the value of properties that make money, like apartments, offices, or stores. This approach works well when the property is expected to keep making money in the future, and its expenses are predictable and stable.
When appraisers use the direct capitalization approach, they go through these steps:
- Find the Expected Yearly Gross Income: They estimate how much money the property could make in a year.
- Consider Vacancies and Lost Rent: They account for times when the property might not have tenants or when rent might not get collected, to get the actual income.
- Subtract Operating Costs: They take away the yearly expenses to find the yearly net income.
- Calculate the Value: They figure out how much an average investor would pay for the income this type of property usually makes. To do this, they estimate the rate of return or capitalization rate.
- Apply the Rate: Finally, they use the capitalization rate to calculate the property’s value based on its yearly net income.
Gross Income Multipliers
We can use the gross income multiplier (GIM) method to appraise properties that aren’t usually bought to make money but could be rented, like single and double-family homes. This method connects a property’s selling price to the expected rental income it could bring in.
For homes, we usually use the monthly rental income, and for commercial and industrial places, we use the yearly rental income. To calculate the gross income multiplier, you do this:
Divide the Selling Price by the Rental Income = Gross Income Multiplier
To find an accurate GIM, we look at recent sales and rental info from at least three similar properties. Then, we use this GIM with the estimated fair market rent of the property we’re interested in to figure out its market value. Here’s how:
Multiply the Rental Income by the GIM = Estimated Market Value
Getting the value of real estate right is crucial for mortgage lenders, investors, insurance companies, and people buying or selling property. Even though experts usually do appraisals, everyone in a real estate deal can benefit from knowing the basics of how property value is determined.