Like everything else in investment, valuation focuses on intrinsic value, this is valuation that is based on fundamentals. However, like I said earlier, real estate valuation is not easy as it is unique, heterogenous and illiquid so its very hard to determine independently. But this does not mean that it can’t be done, it can be done using any of the three approaches.
a. The Cost Approach
b. The Sales Comparison Approach
c. The Income Approach
The Cost Approach
When using this method, our first thought is, what would it cost to replace the building in its present form? We will obviously start with an estimate of the land area, the we would add current construction costs. And this would give us an estimated cost price that we would write down as the value. This is a simple method but I need to point out that it has two shortcomings (i) required land value is not easy to appraise and (ii) the market value of a building could differ significantly to its value of construction. An office building with high rentals, full occupancy will have a higher market value than what the cost approach would predict. And this would also go vice versa, the same office building with low rentals and poor occupancy would have a different value to what the cost approach would offer.
The Sales Comparison Approach
This approach is similar to that popular statement that goes like, “You are the average of the three people that you hang out with”. And this approach is similar to that. Market value is estimated relative to a benchmark value. There is a property that can be benchmarked as the ideal property which is similar or a number of houses in the same area can be valued and the prices get averaged. Then this average price is then adjusted for factors considered to be affecting the property being valued. This average price can be adjusted for changing market conditions, percentage of error in the pricing and the unique features of the property to the benchmark. Let me give a simple example
The Income Approach
This method works on the premise that you will have your rental incomes forever. It therefore, uses a discount type model that uses Net Operating Income (NOI). This is rental income that is believed one will get from the investment in perpetuity reduced for expenses (estimated vacancy and collection losses, insurance, taxes, utilities, repairs and maintenance). This is then divided by the market cap rate, the rate used by the market to capitalise future income into the present market value.
This method relaxes the assumption of constant and perpetual amount of annual income, but we all know that life is not like that, life is unpredictable. Calculations are based on a pretax basis, tax needs to be adjusted for.
There is more to be explored on this topic but let me conclude here for today.