If you are new to buying or selling real estate, you may be curious how property values are determined. This is an important issue, since the calculated value will determine, in part, how much you pay or how much you receive upon completion of the transaction. However, real estate values are applicable to more than just the pricing; they also affect income and insurance considerations.
In the United States, real estate professionals use different methodologies to arrive at property value amounts. Below is more information about two of these valuation methods and what you should know as a buyer or seller.
Sales Comparison Approach
For the average home buyer or seller, the sales-comparison approach is the most commonly used method of real estate valuation. The key word in this method is comparison; the valuation conclusion is based largely upon a direct comparison with other property values.
When using the sales-comparison approach, the valuator, who may be an agent, lender, or appraiser, among other professionals, analyzes real estate transaction data that is closely comparable to the property in question. These properties are usually all approximately the same size, same age, in the same geographic vicinity, and possess other aligned factors.
Next, the valuator then tries to find a way to minimize differences between the comparable properties. A common unit that is often used is square footage; that will enable the valuator to adjust the value of the property in question as needed.
For example, if a 2,000 square foot home is being used as a comparable for a 1,500 square foot home, then the per-square-foot value will need to be calculated and used to compensate for the smaller home. Keep in mind that square footage is not the only common factor, but it is usually the easiest to calculate.
Income Capitalization Approach
Another frequently used valuation method is the income-capitalization approach. This approach is primarily utilized in real estate transactions that involve investment-grade property, such as rental properties or office buildings.
The first step in calculating value based on the income capitalization approach is to determine the net income of a given piece of property. For example, for a property that provides rental income, the valuator would begin by adding total rental receipts for the year.
Next, the valuator would subtract a dollar amount based on vacancies, then subtract overhead expenses and finally arrive at a net income total.
Once the net income total is calculated, the next step is to divide the net income amount by the relevant capitalization rate. The capitalization rate is determined by comparing similar properties and arriving at an average value.
As an example, imagine the net income of a given property is $100,000 annually and the capitalization rate is 7.0 percent. Divide 100,000 by .07, and the calculated value of the property per the income capitalization approach is $1,428,571.
Limitations to Valuation Methods
Even though both the sales-comparison approach and income-capitalization approaches are widely used and have been refined by valuators to a high degree, both methods are still subject to limitations.
For example, the sales-comparison approach depends upon the availability of accurate comparison properties. If such properties are not available for some reason, such as lack of transactions or the unusual nature of a valuated property, then it makes it difficult to find the true value based on this approach.
Likewise, with the income capitalization approach, if comparable capitalization rates are lacking or are inaccurate, that makes finding the value of a property using this method challenging. Other factors that can make property valuation a less-than-exact science including the presence of foreclosures, incorrect financial data, and poorly trained valuators.