(AG Real Estate) Methods of Valuation of Real Estate

Market value is the leitmotiv in the process of real estate appraisal. Valuation can be done for various purposes, the most usual of which are: secured lending; decision-making about real estate investments; accounting reporting; in the process of business decision-making, for the needs of various lawsuits, insurance services, taxation, etc.

Market value is defined as the price (in terms of money), for which a property could be exchanged, in a competitive and open market, under all conditions requisite to a fair sale, and assuming the price is not affected by undue stimulus (absence of any type of concession or enforcement), in the transaction between the interested parties who are well-informed on the relevant facts.

Appraisal is an expert opinion about the value, as well as procedure of determining value, on the basis of systematic approach that includes the following activities:

· Physical and legal identification of the property which is the subject of appraisal;

· Identification of rights on the property that is valued;

· Determination of the purpose of valuation;

· Setting of effective valuation date;

· Collecting and analysis of data that are required for application of appraisal approaches;

· Application of appraisal approaches;

• Making decision about value and designing of report.

In the valuation process, the first and basic assumption is objectivity of the appraiser and absence of any clash of interests. In addition to objectivity, it is necessary to keep in mind the specific professional standards and ethical rules, which are passed by the national associations of appraisers in the world, as well as the Intetnational Valuation Standards Committee, a member of the United Nations. The most important activity in property valuation is, most certainly, application of appropriate approaches and methods of appraisal. According to professional literature and practice, there are three basic approaches in the property valuation procedure:

· Sales comparison approach;

· Income approach;

· Cost approach.

Sales Comparison Approach

The sales comparison approach is based on the market information on sales transactions, or prices from the offers, for the properties that are comparable with the property that is the subject of appraisal. Besides, it is necessary to have these comparable transactions made under normal market conditions and between non – related parties.

It is also necessary to make certain adjustments in the value for all significant differences between the property that is valuated and comperables, on the basis of: location and vicinity of roads; availability of infrastructure, size of the facility and urbanistic parameters; quality of construction; year of construction or adaptation; maintenance and additional investments to the day of appraisal; the time between the transaction and the appraisal day.

The most usual way is to adjust price per square meter of each comparable property, for all percieved differences, so that it could reflect the market value of the subject property. In other words, certain features of comparable properties are adjusted in order to be more similar to the features of the subject property. Characteristics of comparables that are of higher quality than of the subject property will cause the price per square meter to be lowered, whereas poorer characteristics will increase the price. All price adjustments are based on the appraiser’s knowledge of the market and the ways in which certain characteristics can influence the price. This process is subjective to a great extent and it requires an experienced appraiser in order for serious mistakes to be avoided.

Income Approach

This approach is based on the assumption that the value of property depends on its ability to generate profit for the owner. The two methods of this approach that are most often used in practice are:

· Direct Capitalization Method, and

· Discounted Cash Flow Method.

The first of the aforementioned methods is based on the market transactions to a great extent, that is, on the information on rents and selling prices of comparable properties. In that sense, this method is similar to the sales comparison approach, but the difference between them lies in the fact that the focus of this method is on the capacities of comparable real estates to generate income, and in relation of that capacity to their selling prices. That is followed by the capitalization of net incomes. In case of the discounted cash flow method, the future results are being discounted.

Direct Capitalization Method

The first thing that is calculated when this method is used is Net Operating Income (NOI) for comparable properties at the time of their sales, which represents the amount that is obtained when operating costs are subtracted from the property’s gross income (gross rental income and other incomes). Capitalization rate (Cap Rate or R) is obtained when such net operating incomes and selling price are placed in a ratio:

R = Net Operating Income/Selling price,

Value of the property that is subject of the appraisal is obtained when expected net operating income of that property is divided by capitalization rate, which is obtained from the data on the transactions of comparable properties (the average value of capitalization rate in a hypothetical example in the following table is 0.09).

The use of this method does not guarantee to the investor that the purchased property represents a good investment, but it guarantees that the price at which the property was procured is not higher than the competitive price on the market, that is, it guarantees that it is not higher than the price paid by other investors for similar properties.

Capitalization rate is under the influence of the market conditions. In that sense, unexpected growth of supply of commercial space causes the prices of properties to fall and capitalization rate to grow. Because of expected decrease of rental fees and incomes, investors are willing to buy real estates only at lower prices. Higher demand for commercial space has opposite effect. Capitalization rate is also influenced by the changes on the capital market, that is, changes in interest rates. Growth of interest rates causes the growth of discount rate, that is, the required return by investors. Consequently, that leads to decrease of prices and growth of capitalization rate. Drop in interest rates has opposite effect, that is, it leads to growth of prices of real estates and decrease of capitalization rate.

Application of this method always requires large dose of caution when capitalization rate is calculated. The properties that are selected for comparison have to be very similar to the subject property, in almost all important parameters: quality of structure, size, age, functionality, operative efficiency, as well as duration and stability of the lease contracts. Capitalization method is applicable if the real estate that is appraised has stable level of net incomes and when no significant changes are expected in the future. For new, and especially representative and unique properties, and for valuation of the development projects, the most reliable is the discounted cash flow method, which represents the income approach in the most realistic way.

The Discounted Cash Flow Method

This method is based on the assumption that the investor, at the final instance, will not buy some real estate for the price that is higher than the present value of future incomes that property can generate over an infinitely long period of time.

The appraiser, on the basis of his knowledge of market, supply and demand, future economic perspectives, lease terms, as well as structure of incomes and costs, makes the projection of future results, that is, annual incomes of the subject real estate. The results are projected until the moment when their stabilization is expected (holding period), and then, on the basis of the stabilized result, so-called residual value in residual period (reversion value or resale price) is determined. Approximation of the residual value is obtained when net operating incomes in the first year, following the projection period, are divided by so-called terminal capitalization rate, which depends on the growth of net operating incomes within residual period.

Conversion of future incomes into their present value is carried out through discount rate, which represents minimum required rate of return on invested capital, in accordance with the risk related to real estate investments. It is well known that alternative investments involve different levels of risk. Thus, investment in real estates is riskier than the investment in the government bonds or in the commercial and municipal bonds, but it is less risky than the investment in stocks. Therefore, the discount rate is calculated starting from the risk-free rate, such as rate on government bonds, and then the premiums for systematic and specific risks are added. Premium for systematic risk concerns the risk that is common for all entities in one economy (country risk) and it is an indicator of macro-economic conditions, such as fiscal changes, fluctuations of exchange rates and interest rates, as well as all other events that cause instability. Specific risk includes factors that are unique for the concrete type of business, which is, in this particular case, real estate business. It should be pointed out that the discount rate, obtained in this way, reflects the average risk and average returns for the sector of commercial properties as a whole. Risk for certain types of property can be either higher or lower than the average, which means that the expected return can be either smaller or bigger than the average.

Present value of the real estate is then determined by summing present values of net incomes within the projected period of time and present value of the calculated residual value. If the value obtained in this way is higher than the invested money, or the purchase price, that means that the the developer or investor achieved Internal Rate of Return, that is higher than the marginal rate, i.e. minimum required rate, defined by the discount rate.

Cost Approach

The use of the cost approach in the real estate appraisal is based on the assumption that the investor will not pay for some real estate more than it costs him to buy the land and construct the object.

The cost approach is based on determination of the price of new construction, that is, the costs of replacement of existing property, including all costs (construction costs, permits and documentation, fees and taxes for primary land development, utilities and related installations). Value of the newly constructed building obtained in this way is then reduced for all physical and functional depreciation in value, in order for the current estimated value to be determined. Value of the accompanying land is added on this value, in accordance with available comparable data from the market. It can be deduced from the above that it is much easier to apply the cost approach on newer structures than on older properties because the estimate of development costs for the latter would be more difficult and complex.

The cost approach is most often used when dealing with special use properties for which it is difficult to find comparables on the market.

Instead of Epilogue

Valuation is the projection of prices and values, based on the current market conditions and available information at the time of appraisal, and not a guarantee. Different appraisers, applying the correct methods and procedures, can come to different opinions about value. Conditions on the market are the conditions of uncertainty and changes, and the results of appraisal must be interpreted in the light of that uncertainty. Definition of the market value requires from the appraiser to find the maximum value, while it is considered as acceptable in practice that the appraisers express their opinions within some range of possible values. Various combinations of presented approaches and methods can be used in the process of real estate appraisal. Selection of the method should depend on the quality and availability of data. In theory, in the conditions of existence of perfect information, correct application of any method would lead to identical result. However, in reality and practice, where there is no perfect information, these methods are supposed to correspond one to another and valuations are most often done on the basis of application of at least two approaches. Also, investors, creditors and owners of real estates should be familiar with the appraisal methods and the assumptions preceding the appraisal. The appraisal should be supplement to, not a substitute for, thorough investment analysis and due dilligence carried out by investor.

Miljan Pavlovic, MSc

Head of Consultancy Department

Forton International,

Associate Office of Cushman&Wakefield

mpavlovic@forton.bg