Before possessing an asset via purchase, especially a property, it is necessary to run an appraisal to determine its market value. This appraisal can be approached through three means: the income approach, the cost approach, and the sales comparison approach.
1) The Income Approach
The income approach is an appraisal method that permits appraisers to evaluate the worth of a property based on the income the property is expected to generate. It is often termed the income capitalization approach.
This approach will require you to take the net operating income (NOI) of the rent received and divide it by the capitalization rate.
The capitalization rate covers investment risk. It is calculated based on the property’s Interest Before Depreciation, Interest, and Taxes (IBDIT), bearing in mind the equity investment of appraised the property.
In addition, the present interest rate on the property’s mortgages and the risk factor to cover the investment risks are also considered.
The income approach is affiliated with discounted cash flow (DCF) used in finance. With the aid of the capitalization rate, the income approach makes it easy to discount the future value of rents.
To calculate a property’s worth using the income approach will require the application of this formula:
Property Value = NOI / Cap. Rate
- NOI is Net Operating Income and,
- Cap Rate is Capitalization Rate
For example, a tenement building has a net operating income of $1,000,000 and a capitalization rate of 10%. What will be the value of the property?
Value = NOI / Cap rate
= 1,000,000 / 0.01
The property’s worth using the income approach is $100,000.
Using the income appraisal method will also require the investor to carefully check the property’s condition, as heavy repairs in the future may creep into the estimated profit to be generated.
2) The Cost Approach
The cost approach appraisal of real estate properties is based on the assumption that the worth of a property in a location should cost the same as building the property from the beginning.
Therefore, rather than find out the price of similar properties in that particular location, the appraiser instead finds the worth of rebuilding the property with the present value.
Thus, the appraisal captures the value of the local site of the land. It also estimates land’s worth but deducts the cost of depreciation of improvements or loss of value. In some climes, what is referred to as the contractor’s valuation method is the same as the cost approach.
The cost approach appraisal uses the following formula for its calculation:
Property Value = Replacement/Reproduction Cost – Depreciation + Land Value
Steps in Cost Approach Appraisal
There are five significant steps to evaluating a real estate asset using the cost approach, and they include the following.
#1. Estimate the reproduction or replacement cost of the structure
This step requires you to estimate the cost of rebuilding the property and upgrading the location. The cost will be based on the present time value. This can be calculated via two methods.
The reproduction method requires an estimation of the cost of replicating the appraised property.
It would involve using similar building materials and construction patterns, even in layouts, designs, and standards, used when the property was initially built.
This method assumes that the new property has the same pattern but currently trending materials, using prevailing construction methods and upgraded design.
#2. Estimate the depreciation of the improvements
Depreciation usually causes disparity in the value of properties and their improvement between times.
Depreciation is generally known as a reduction in the value of an asset. Determining the depreciation will require you to consider the economic, physical, functional depreciation.
Physical depreciation has to do with the tears and wear of the property. Functional depreciation relates to changes in customers’ preferences and tastes. While economic depreciation has to do with unfavorable economic activities like recession
#3. Estimate the Current Land Market Value.
This step requires you to obtain the worth of the land using the present time value, that is, how much the land is worth today.
#4. Deduct accrued depreciation from the cost
At this point, you will have to subtract the estimated accrued depreciation of improvements from your cost, be it from the replaced or the reproduced cost as was used.
#5. Add the property depreciation cost to the estimated land value.
The final step requires you to add up the cost of depreciation to the estimated land value.
For example, given that replacement/reproduction cost is $3,000,000, accrued depreciation is $300,000, depreciated cost of the property is $700,000, the estimated value of the land is $950,000. Find the Value of the Real Estate Property.
Replacement/Reproduction Cost = $3,000,000
Less: Accrued Depreciation = $300,000
Depreciated Cost of the Structure = $2,700,000
Add: Estimated Value of the Land = $950,000
Total Value of the Real Estate Property $3,650,000
3) The Sales Comparison Approach
The sales comparison approach with the acronym SCA is the first appraisal that comes to mind when comparing properties is involved.
SCA is one of the major tools used in comparative market analysis (CMA). CMA is an analysis that compares properties that have similar features and are within the exact geographical location, with attention to their prices.
The sales comparison approach compares properties that were recently sold and similar to the property in consideration.
One of the features of the real estate market is its dynamism. In the sense that the price of properties changes constantly, it is necessary for investors and appraisers to regularly keep tabs on the costs of properties that are recently sold.
During the sales comparison of the product, the appraiser should check out a minimum of four recently sold properties to get accurate data.
You can determine the market value of the property using the sales data collated from the property evaluation. As comparison is made, the price of the appraised property can be adjusted to fit the prevailing market trend.
Peradventure, the appraised property does not have a given feature found in other compared properties.
Hence, the cost is changed downwards as indicated by the worth credited to the missing element. Conversely, if the property possesses a vital feature not found in other compared property, the worth should be increased appropriately.
The sales comparison approach of property evaluation frames an essential piece of the comparative market examination for appraisal experts.
Moreover, the comparative market approach is the premise of deciding the overall market incentive for property procurement.
Therefore, the sales comparison approach is considerable for real estate dealers, financial investors, appraisers, and any other interested entity as a team with different appraisal strategies.
The real estate market changes quickly, and all involved individuals ought to be updated about the latest trends in the market.
Based on the prevailing market conditions, traders and financial investors can either increase or lower their requests to be at standard with the market patterns.
The Sales Comparison Approach uses the sales data of similar properties within the location of the appraised property to determine the property’s market value.
On the other side, the cost approach method assumes that potential investors should pay the price equal to the cost of building the property from scratch.
And finally, the income approach appraisal method permits potential investors to estimate the appraised property’s value based on the income the property generates.