Estimating the value of real estate is necessary for a number of endeavors, including financing, sales listing, investment analysis, property insurance, and taxation. But for a lot of people, determining the asking or price of a bit of real property is the most useful application of property valuation. This article provides an introduction to the essential concepts and methods of real estate valuation, particularly as it pertains to sales.
KEY TAKEAWAYS
Valuing real estate is difficult since each property has unique features such as for example location, lot size, floor plan, and amenities.
General real estate market concepts like supply and demand in confirmed region will certainly play right into a particular property's over-all value.
Individual properties, however, must be at the mercy of appraisal, using one of the methods, to ascertain a fair value.
Basic Valuation Concepts
Technically speaking, a property's value means the present worth of future benefits arising from the ownership of the property. Unlike many consumer goods that are quickly used, the benefits of real property are generally realized over a long time frame. Therefore, an estimate of a property's value must take into consideration economic and social trends, in addition to governmental controls or regulations and environmental conditions that could influence the four components of value:
Demand: the desire or dependence on ownership supported by the financial methods to satisfy the desire
Utility: the opportunity to satisfy future owners' desires and needs
Scarcity: the finite supply of competing properties
Transferability: the ease with which ownership rights are transferred
Value Versus Cost and Price
Value isn't necessarily equal to cost or price. Cost identifies actual expenditures ? on materials, for example, or labor. Price, on the other hand, is the amount that someone will pay for something. While cost and price can affect value, they do not determine value. The sales price of a house may be $150,000, but the value could be significantly higher or lower. For instance, if a new owner finds a serious flaw inside your home, for instance a faulty foundation, the worthiness of the house could be lower than the price.
Market Value
An appraisal can be an opinion or estimate regarding the value of a specific property as of a particular date. Appraisal reports are used by businesses, government agencies, individuals, investors, and mortgage companies when coming up with decisions regarding property transactions. The purpose of an appraisal would be to determine a property's market value ? probably the most probable price that the house will bring in a competitive and open market.
Market price, the price at which property actually sells, might not always represent the marketplace value. For example, in case a seller is under duress because of the threat of foreclosure, or in case a private sale is held, the house may sell below its market value.
Appraisal Methods

An accurate appraisal depends on the methodical collection of data. Specific data, covering details concerning the particular property, and general data, pertaining to the country, region, city, and neighborhood wherein the house is located, are collected and analyzed to reach at a value. Appraisals use three basic methods to determine a property's value.
Method 1: Sales Comparison Approach
The sales comparison approach is commonly used in valuing single-family homes and land. Sometimes called the marketplace data approach, it is an estimate of value derived by comparing a house with recently sold properties with similar characteristics. These similar properties are referred to as comparables, and in order to provide a valid comparison, each must:
Be as similar to the subject property as possible
Have been sold within the last year within an open, competitive market
Have already been sold under typical market conditions
At least 3 or 4 comparables should be found in the appraisal process. The most important factors to consider when selecting comparables are the size, comparable features and ? perhaps most of all ? location, which can have a tremendous influence on a property's market value.
Since no two properties are exactly alike, adjustments to the comparables' sales prices will undoubtedly be made to take into account dissimilar features along with other factors that could affect value, including:
Age and condition of buildings
Date of sale, if economic changes occur between your date of sale of a comparable and the date of the appraisal
Conditions and terms of sale, such as for example in case a property's seller was under duress or if a property was sold between relatives (at a discounted price)
Location, since similar properties might differ in price from neighborhood to neighborhood
Physical features, including lot size, landscaping, type and quality of construction, number and type of rooms, square feet of living space, hardwood floors, a garage, kitchen upgrades, a fireplace, a pool, central air, etc.
The marketplace value estimate of the topic property will fall within the number formed by the adjusted sales prices of the comparables. Since some of the adjustments made to the sales prices of the comparables will be more subjective than others, weighted consideration is normally directed at those comparables which have the least quantity of adjustment.
Method 2: Cost Approach
The cost approach may be used to estimate the value of properties which were improved by one or more buildings. This method involves separate estimates of value for the building(s) and the land, taking into consideration depreciation. The estimates are added together to calculate the worthiness of the complete improved property. The price approach makes the assumption that a reasonable buyer would not pay more for an existing improved property than the price to buy a comparable lot and construct a comparable building. This approach is useful when the property being appraised is really a type that's not frequently sold and does not generate income. For example schools, churches, hospitals and government buildings.
Discover more could be estimated in several ways, including the square-foot method where in fact the cost per square foot of a recently built comparable is multiplied by the amount of square feet in the topic building; the unit-in-place method, where costs are estimated based on the construction cost per unit of way of measuring the average person building components, including labor and materials; and the quantity-survey method, which estimates the levels of raw materials which will be needed to replace the subject building, along with the current price of the materials and associated installation costs.
For appraisal purposes, depreciation identifies any condition that negatively affects the value of an improvement to real property, and takes under consideration:
Physical deterioration, including curable deterioration, such as painting and roof replacement, and incurable deterioration, such as for example structural problems
Functional obsolescence, which identifies physical or design features which are no longer considered desirable by home owners, such as for example outdated appliances, dated-looking fixtures or homes with four bedrooms, but only one bath
Economic obsolescence, caused by factors that are external to the property, such as being located near a noisy airport or polluting factory.
Methodology
Estimate the value of the land as if it were vacant and open to be put to its highest and best use, using the sales comparison approach since land cannot be depreciated.
Estimate the existing cost of constructing the building(s) and site improvements.
Estimate the quantity of depreciation of the improvements caused by deterioration, functional obsolescence or economic obsolescence.
Deduct the depreciation from the estimated construction costs.
Add the estimated value of the land to the depreciated cost of the building(s) and site improvements to look for the total property value.
Method 3: Income Capitalization Approach
Often called basically the income approach, this technique is based on the relationship between the rate of return an investor requires and the net income a property produces. It is used to estimate the value of income-producing properties such as apartment complexes, office buildings, and shopping malls. Appraisals using the income capitalization approach can be fairly straightforward once the subject property can be expected to create future income, and when its expenses are predictable and steady.
Direct Capitalization
Appraisers will perform the next steps with all the direct capitalization approach:
Estimate the annual potential revenues.
Consider vacancy and rent collection losses to look for the effective gross income.
Deduct annual operating expenses to calculate the annual net operating income.
Estimate the price that a typical investor would purchase the income produced by this type and class of property. This is accomplished by estimating the rate of return, or capitalization rate.
Apply the capitalization rate to the property's annual net operating income to create an estimate of the property's value.
Gross Income Multipliers
The revenues multiplier (GIM) method may be used to appraise other properties which are typically not purchased as income properties but that could be rented, such as one- and two-family homes. The GRM method relates the sales price of a house to its expected rental income. (For related reading, see "4 Methods to Value a Real Estate Rental Property")
For residential properties, the gross monthly income is normally used; for commercial and industrial properties, the gross annual income will be used. The gross income multiplier method can be calculated as follows:
Sales Price � Rental Income = Gross Income Multiplier
Recent sales and rental data from at the very least three similar properties can be used to establish an accurate GIM. The GIM can then be employed to the estimated fair market rental of the topic property to determine its market value, which can be calculated as follows:
Rental Income x GIM = Estimated Market Value
The Bottom Line
Accurate property valuation is essential to mortgage lenders, investors, insurers and buyers, and sellers of real property. While appraisals are usually performed by skilled professionals, anyone involved with a genuine transaction can benefit from gaining a basic understanding of the different methods of real estate valuation.