To be able to value real estate is a fundamental skill for investors, buyers, sellers, and industry professionals. Accurately determining the value of a property is crucial for making informed decisions. Whether it’s buying, selling, annual valuation, or a strategic investment review of your portfolio, valuing accurately is key.
In this blog post, we will provide a comprehensive guide on how chartered surveyors value real estate. Moreover, there are various methods available to value any type of real estate. Being a member of the Royal Institution of Chartered Surveyors (MRICS) personally provides the knowledge to talk through the five methods to value real estate. The RICS’ red book governs how professionals should value real estate across the world. We will explore the five valuation methods set out by the RICS.
In this session, we will explore the five valuation methods outlined by the Royal Institution of Chartered Surveyors (RICS). We will delve into the key factors to consider when applying each method. Furthermore, the appropriate scenarios for using each approach and the important aspects to be aware of for each valuation technique.
By understanding the valuation process, you can make more informed decisions and navigate the real estate market with confidence.
WHAT IS THE RICS?
The RICS has been around for over 150 years and sets the standard for over 130,000 members globally. It establishes and upholds the highest international standards for real estate. This includes the development and management of land, transactions, construction, and infrastructure across more than 140 countries. To learn more about the RICS and further qualifications, the following link will provide more detail RICS Accreditation (rics.org).
WHAT ARE THE 5 METHODS for valuing REAL ESTATE?
1. MARKET COMPARISON METHOD
The comparison method is the most widely used method for valuing real estate. This technique involves comparing the property in question to similar properties that have recently sold in the same market. Appraisers analyse factors such as location, size, condition, tenure, transaction date, amenities, and recent sales prices, and then make adjustments to determine the property’s value.
This market comparison approach provides a reliable and data-driven assessment of the property’s worth, as it relies on actual market transactions and comparable properties. By carefully analysing these factors, appraisers can arrive at a well-informed and defensible valuation of the property.
When do you use the comparable method to value real estate?
This approach is particularly useful for residential properties and relies on the principle of supply and demand in the local market. You need to have an established transactional market to adjust comparable properties to the subject property. The owner occupier market drives the price of these types of properties.
You also use the comparison method when valuing through the investment method, the depreciated cost method, and the profits method. The comparison method helps establish the market yield for an asset to capitalise on the annual rent or profits to obtain the capital value.
2. INVESTMENT METHOD TO VALUE REAL ESTATE
The investment method, also known as the income approach, focuses on the property’s ability to generate rental income. To value using this method, you need to estimate or know the property’s gross operating income (GOI) and apply a capitalization rate. The capitalization rate reflects the standard market yield or return on investment that investors would likely achieve at that current time in the market. The yield will be different depending on the asset class, location, quality, etc. This is the aspect of the investment method that incorporates the comparable method to help establish the yield. The calculation is as follows:
(gross operating income/annual rental income) ÷ Market Yield = Valuation
Say: £100,000 a year in rental income ÷ 5% market yield = £2,000,000 in the market value of the asset.
When do you use the investment method?
The investment method is for properties that produce rental income, such as commercial buildings or multi-dwelling residential buildings. These properties project a value based on their appeal to investors instead of the owner-occupier market.
The two main drivers of the value of commercial properties are the risk and the income from the investment. The yield chosen shows the amount of risk the investment presents. The higher the yield, the higher the return on investment you can achieve, although the risk of achieving that return is also higher. As a rough rule of thumb, the following is a good guide to follow:
- A low-risk investment would dictate a yield of 1%-3%.
- A medium risk investment would dictate a yield of 4%-6.5%
- A higher-risk investment would dictate a yield of 7% -10%.
3. Replacement Cost valuation APPROACH
The cost approach estimates the value of a property by considering the cost to replace or reproduce it. This method is particularly relevant for unique or specialised properties where comparable sales data is unattainable.
The method involves splitting the property into parts, such as the land and buildings, and then valuing the separate elements. Firstly, estimate the land value by using comparables of other small land parcel transactions in the area. Then add the cost of constructing or replacing the buildings, and then adjust for depreciation. The cost approach does not consider market conditions or income potential but focuses on the property’s physical characteristics and construction costs.
When do you use the replacement cost method to value real estate?
The cost approach is for property such as churches, schools, or libraries. These assets don’t transact regularly. Moreover, they don’t generate income or profits, so the cost depreciation method is the only way to establish the value of these assets.
4. PROFITS METHOD
This method estimates the gross profits of the business within the property, deducting all work expenses and rental payments to give the divisible profit balance. This balance excludes any debt payments or directors’ salaries. The profit method is for a business property that has the characteristic of a monopoly. Furthermore, the value of the property depends on the commercial value of the business occupying it. The capitalization rate of the profits is from comparable transactions of that asset type.
When do you use the profit method?
For properties where the business that is run there drives the value of the property, then the profit method is the best way to establish value. Examples of such properties are hotels, nurseries, and pubs.
5. RESIDUAL METHOD TO VALUE REAL ESTATE
Residual valuation is a method used in real estate development and investment analysis to estimate the value of a property based on its potential future value. The process involves determining the estimated sales proceeds of the property and subtracting the costs associated with development or construction. This residual value represents the maximum amount that can be paid for the property while still achieving the desired return on investment.
To perform a residual valuation, significant market research, demand analysis, and financial projections are made to estimate the sales price (gross development value (GDV)).
The costs to construct the property are subtracted from the GDV. This includes construction expenses, professional fees, financing costs, contingencies, developer profits, and other related expenses. By deducting these costs from the GDV, the residual value can be set. The residual value is the top-level value that the undeveloped property is worth to a developer in its current state.
When do you use the residual method?
Residual valuation is particularly valuable for assessing undeveloped land, properties with redevelopment potential, or income-generating properties with room for value enhancement. However, the method is only for properties that have planning consent or that is in local planning policy. If properties don’t have that planning guarantee, then you would value the asset by using one of the other four methods, depending on their type. Although using the residual valuation method helps investors and developers make informed decisions about property acquisitions without planning. By being aware of the property’s potential value and associated costs if you were to obtain planning after purchasing a property.
VALUATION SUMMARY
Valuing real estate is a multidimensional process that requires a comprehensive analysis of various factors and considerations. By utilizing the five different valuation methods, you can determine the value of any type of property depending on its unique characteristics and income potential.
The comparable method is fundamental to all valuation methods, so ensuring you understand this method first is essential. Whether you are buying, selling, or investing in real estate, understanding the valuation process empowers you to make well-informed decisions and navigate the dynamic real estate market effectively.
