Real Estate Valuation Methods

Hannah Griffith
6 min read
August 23, 2022
real estate valuation methods

Estimating the value of the real estate is essential for several purposes, such as financing, sales listing, investment analysis, property insurance, and taxation. The most practical use of real estate valuation is in establishing the asking or purchase price of a piece of real estate. This article will present the essential concepts and practices of real estate valuation, particularly as they apply to transactions. These are the three most popular real estate valuation methods out of the many available options:

  • The sales comparison strategy evaluates the property compared to similar properties previously sold nearby.
  • Cost strategy considers the cost of constructing a similar structure.
  • Income or investment strategy examines the income that the asset being appraised is currently or possibly generating.

Each valuation technique is independent of the others; thus, an appraiser will typically choose one method over a combination of the other two when determining the worth of a particular piece of property. The lender in question may specify the approach to be taken. Additionally, each method can lead to somewhat different appraisals, so it's vital to understand which method your selected lender is employing. 

What is Real Estate Valuation? Why carry out a real estate appraisal for an estate?

Practically speaking, the real estate valuation or value of a property is the present value of all potential future gains resulting from ownership. The advantages of real estate are typically experienced over a lengthy period, unlike many consumer goods that are quickly consumed. 

After the death of a person, his heirs must carry out the valuation of the real estate of which the estate is composed. This estimate must meet many legal criteria to ensure the proper management of the estate. First of all, it must transcribe the market value of the property according to the state of the market at the time of the testator's death.

Indeed, the market value of the property estimated during the expertise will result in the inheritance costs that the legatees will have to pay. For this reason, some would like to underestimate the value of a property to reduce the amount of fees they must pay.

Best Real Estate Valuation Methods

Real estate differs from purchasing commodities and services like food, gadgets, or other items. Neither a fixed price nor a definite value is attached to properties. Instead, similar to stocks, their values fluctuate regularly depending on how much people are ready to pay for them. 

The methods used to evaluate the worth of a real estate investment are comparable to those employed in fundamental stock analysis. Analyzing the cash flow and the subsequent rate of return is essential to accomplishing the goal of making profitable investments because real estate investment is often not a short-term trade.

Market/Sales Comparison approach Strategy of real estate valuation

One of the most vital components of valuable real estate is comparisons to market parameters. In reality, information on reproduction costs, current market capitalization rates, loan-to-value ratios, and other topics are frequently derived from sales comparisons.

Analyzing other recently sold homes on the market is part of the sales comparison strategy. The following list is not all-inclusive but does include some of the significant elements found throughout the comparison analysis: 

  • Pricing factors include cost per square foot.
  • Cost per unit (multifamily) & cost per key (hospitality). 
  • Capitalization rate (what cap rate did other properties sell for). 
  • State of property health and location. 
  • Profiles of tenants' earnings (credit quality of tenant, stability of cash flows, etc.).

An analyst can be more confident in the measures used for real estate valuation if the comparable properties are more similar to the subject property in terms of kind, location, usage, condition, etc. After contrasting the features of the subject property with those of the comparable properties, modifications are made to reflect any features that are either more or less beneficial for the subject property, and then a final determination of value is established.

A fantastic way to learn how the market values homes comparable to the subject property is to look at recent sales. Similar to the cost strategy discussed below, the sales comparison method fails to account for the long-term cash flows that investors can anticipate while holding the property or selling homes.

Cost Approach

The cost approach includes the value of the land when estimating the cost of building the construction from the ground up (i.e., on an empty plot of land). When using the cost technique, the goal is to compare the costs of buying an existing home value vs. starting from scratch on a new one.

The cost approach primarily employs two approaches:

  • The reproduction method is known as the cost of reconstructing a precise replica of an existing structure using the same materials, construction techniques, and other factors.
  • The price of reconstructing the structure using new components, techniques, and designs is known as the replacement method.

Although the rationale is solid, this approach fails to consider the additional development and construction work required to build a property from the ground up. Additionally, a property's prospective long-term cash flow is not considered.

Income or Investment Strategy

This strategy frequently referred to as just the income approach, is based on the correlation between the rate of return that an investor needs and the net income that a property generates. It determines the value of properties that generate income, such as office buildings, shopping malls, and residential complexes. When the subject property can be projected to generate future revenue, and when its expenses are predictable and stable, appraisals utilizing the income capitalization approach can be reasonably simple. The fundamental tenet of the income strategy is that an investor will be more prepared to pay more for a property if it has better revenue potential. The value assigned to a property's income or investment may be more or lower than its worth in the market.

The Bottom Line of Real Estate Valuation Methods

  1. Picking the best real estate valuation technique is similar to picking the best tool for a job. Most decisions are made on a case-by-case basis using the most accurate information available. However, due to the various subjective methodologies and data, asset evaluation is both a science and an art in business.

  2. Most importantly, you must know how to calculate property taxes? While using any of the real estate valuation methods as property taxes are a high cost of homeownership, and under each method, property tax calculation can be irritating and perplexing.

  3. When it comes down to it, most appraisers don't stick to just one approach; instead, they average two or more ways. The $8.9 trillion worldwide commercial real estate market can be illuminated by understanding the factors considered in each assessment decision.