The first article in the Property Investment Tips series on Property Valuation Methods looks at The Market Data Approach.
The market data approach to valuation looks at recent sales of comparable properties in order to ascertain a market value of the property. This approach relies on the marketplace dictating the acceptable price of property in an open market situation. One valuation principle that this approach relies on is the principle of substitution. The substitution principal dictates that a practical purchaser is believed to pay no more for a property or rental than it would cost to buy or rent an equally desirable alternative property that is on the market. Essentially what this is saying is that, people will not pay more for one particular property when there is an equally desirable property available for a lesser price.
Worldwide economic conditions have seen jobs lost and businesses close. With limited jobs available, the number of consumers who have defaulted on mortgage payments has increased. The flow on effect from this is that there has been a steady increase in the number of forced sales of residential properties through mortgagee and foreclosure situations. At the same time, financial markets around the world have had to tighten lending conditions due to a shortage of money flowing around the world. Interest rates, lending guidelines and requirements for greater equity behind investments have all contributed to a decrease in the number of active investors in the marketplace. Governments around the world are also getting involved, finding ways to regulate their respective property markets.
So in effect we have three different scenarios affecting the market, in very different ways. On one hand we have forced sales due to inability to pay for the associated lending against the property, and on the other we have tighter lending conditions for people looking to enter the market and we also have uncertainty surrounding the tax and structure of investment properties from the government. All these issues have the same outcome, which is to generate caution within the real estate market and reduce prices of those that are on the market.
In this current situation, it would seem that the market data approach to valuations may be the most appropriate. Given that so many variables are interfering with the value of homes, the best way to determine what a fair price is, would be to look at the most recent sales for comparable properties. The drawback to this approach would be that some of the comparable sales may have been under a forced sale condition and hence may not necessarily be in an open market environment. A counter argument to this could be that due to the number of people exiting the market at this point in time, especially through forced sale conditions, then this is in fact a reflection of the current market, and hence prices are fairly reflected. As prices are considered to be low (compared to 12-24 months ago) then it could be argued that those who are trying to sell their property at the moment, are only doing so because they need to do so for some reason, for example upgrading property or leaving the country etc. If you did not have to sell at the moment, when prices are down, then why would you? The substitution principal supports this methodology in the fact that people will only want to pay the cheapest price for an equivalent property, all things being equal.
Another drawback to the market approach is the heterogeneous nature of property, meaning that no two items of land are the same. For the market approach to work (a comparison of similar properties needs to be collected). This means, properties with similar sized sections in the same area, with similar sized and aged dwellings and improvements on the site. Nowadays many new developments are built to similar specifications (same house design on multiple sections) and hence new areas of cities can all look very similar. This works in the market approach’s favour as determining comparable sales is easier.
Next up on the Property Investment Tips series on Property Valuation Methods is The Cost Approach.
Click here to read the Cost Approach to Property Valuation.