As the economic environment brings about change, so property valuation must change to meet these new conditions. For property investors the value of a property affects everything from the purchase, property income, and importantly the investor’s ability to leverage for further investment. Before looking at any property valuation, an extremely important property investment tip is to understand what approach or property valuation method was used to determine it. From there you can cast a more critical eye over this vital element of property investment.

Property Investment Tips will look at the three most common methods of valuation and compare them as to how they relate to property valuation in 2010. There are three basic valuation approaches used to value property, with each using different means of finding the property’s place in the market. The methods include ‘the market date approach’, ‘the cost approach’ and ‘the income or investment approach’. The market data approach looks at the value of property sales in the area and finds how this property compares to the ones that have been sold. The cost approach uses the actual value of land and how much the property cost to build. The income or investment approach uses a formula based on the cost and income of a property to determine its value.

This series of property investment tips on property valuation articles will discuss the three different property valuation methods. The first article will discuss the market data approach, the second the cost approach and the third will explain the income or investment approach.

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Next: The Market Data Approach.

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.

The second article in the Property Investment Tips series on Property Valuation Methods looks at The Cost Approach.

The cost approach takes a different look at the value of a property. Essentially the value of the property is derived by first establishing the value of the land or section (the market approach may be used for this) then adding to this is the current value of the structure (adjusted for depreciation) and other improvements to give an overall value for the property. This approach has some limitations in terms of residential valuations, the key one being able to accurately calculate the depreciated value amount of the building and improvements. One situation where it would be used in the residential market would be to calculate the value of a property that is yet to be constructed.

An ‘on completion’ valuation would take into account the land value and the construction costs to determine the final value of the finished product. This is a highly subjective technique and can vary from valuer to valuer. There are times where external influences may interfere with this method, one of those being a market where supply is short and demand is high, in cases like this the value of an older property under the cost approach may not be in line with the value of the property using the market approach. The heterogeneous nature of property plays into the cost approaches technique when it comes to unique homes and properties. Where there may not be suitable comparable sales under the market approach, the value can be assessed by determining the land and building cost.

One needs to be careful when using this method that the amount spent on the property may in some cases not accurately reflect its value. A unique architecturally designed home that has had no expense spared in terms of its construction, may have been overcapitalised and the final value would be less than the actual construction costs. A couple building their dream home in which they plan to retire in may undertake such a development. In a situation like this, the valuer would need to apply common sense and perhaps undertake an additional valuation approach in order to conclude a fair value. The substitution principal is one of the paramount considerations to apply in the cost approach to valuation, taking into account that someone will not pay more for a property that they could acquire a similar site and construct a similar building for a cheaper price.

Next up on the Property Investment Tips series on Property Valuation Methods is The Investment or Income Approach.

Click here to read the Investment or Income Approach to Property Valuation.

The investment or income approach to property valuation looks at the income producing potential of a property and determines a value based on this. It is ideally suited to situations where the property in question is to be used as an income producing investment. By assessing the “present value of future benefits of future ownership” the income approach can determine the suitability of an investment. This method is not very common in application for residential investments due to the market approach being a more consistent and proven method. The income approach is used on a number of commercial property valuations but is often overlooked in residential. For this method to work, a suitable capitalisation or cap rate must be determined, which is then used to determine the total value of the property based on the proposed income stream. To determine the income stream, a fair rental amount must be calculated. This is then summed to come to a total amount for the year and depending on what the cap rate is, a final value is reached.

For example a 3 bedroom home may attract $350 pw in rent. Over a year this calculates to $18,200. Assuming the valuer used a cap rate of 5%, the total value of the property would be $364,000 ($18,200/5%). This may seem to be a reasonable assessment of the buildings value and not far off the mark for a house in that particular area. The issue lies in determining an appropriate cap rate. How was that 5% determined? Depending on the location (town, suburb, street) a different cap rate would need to apply. Using the market approach in that same area, we can work backwards to determine the cap rate. We take two properties, one in a new suburb that is classed as highly desirable, the other in a older suburb that is classed as less desirable. Their respective values are $350,000 and $240,000 (this example from my actual portfolio). The $350,000 home has a fair market rental figure of $360 per week or $18,720 per year. This equates to a cap rate of 5.35% ($18,720/$350,000). The less desirable house has rental income of $285 per week or $14,820 per year. This equates to a cap rate of 6.18% ($14,820/$240,000).

In the commercial property market, it is easier to determine the cap rate of a property, as the market values of similar properties are found using the market approach, the rent or lease returns are easier to calculate and from there a cap rate is found. By assessing the cap rate of a number of similar properties an appropriate rate can be found and based on the existing lease and expense details a fair value can be determined.

Click here to read the conclusion of the Property Investment Tips series on Property Valuation Methods.

Property Valuation Methods: Conclusion.

Finally, the conclusion of the Property Investment Tips series on Property Valuation Methods

As we can see, the three valuation techniques discussed in this series all use different methods to determine the value of a property, and all three have different situations and property types where their use may be more appropriate.

The market data approach determines the value of a property based on sales of similar properties in the area. This is the most commonly used method of residential valuation but has limitations in the fact that all property is heterogeneous and sometimes locating sales of a similar property may be difficult. The cost approach assesses the value of the land and then determines the depreciated cost to construct the building and improvements that exist on the land. This approach is suited to properties that may be difficult to value under the market approach. Properties that have one-off designs, unique construction or special purpose properties are all difficult to compare and so a cost approach may be a better method to use. The limitations of this method become apparent when a building has been built at great expense and is actually worth less than it costs to build; overcapitalisation of a property can be difficult to account for under the cost method. Finally the income, or investment, approach to valuation looks at the income earning potential of a property and bases the value of the property on the projected revenue that the building can earn. This method is extensively used when valuing income producing properties such as commercial buildings, but is not often used in the residential market due to the difficulties in assessing a fair income return on the property. In the case of an owner occupied home, the income potential from the home may be argued as being zero.

The best property investment tip is to use combination of the three valuation methods is recommended. By applying one technique and then confirming this through a second or third method, an accurate idea of the property’s value can be determined. Of course, the more experience that a valuer has in a particular market, the greater ability they will have in determining an accurate value and only one method may need to be applied.