Valuation of real estate refers to the estimation of the most likely selling price (market price) or the worth of the property to an individual or group of individuals i.e. investment value (Baum and Crosby, 2008). There are many valuation methods. Methods such as the sales comparison, single capitalisation as well as the term and reversion are considered traditional approaches while others such as the discounted cash flow (DCF) and arbitrage valuation models are considered contemporary valuation approaches. Traditional valuation approaches are backward-looking, based upon the principle that a property’s value depends upon its economic and physical characteristics. On the other hand, contemporary valuation approaches are forward-looking, risk-adjusting, growth-explicit models based on the principle that a property’s value depends upon the property’s future net cash flow (Crosby, 1996; Ambrose, 1991).
Choosing a valuation method
There are important factors that one should consider when choosing a valuation method. Some of these factors are discussed below:
Theoretical soundness of the valuation method
The concept of value is an economic concept, anchored in finance. An acceptable valuation method must conform to some recognisable economic concept of value. In other words, a valuation method should be theoretically sound, based on firm economic theory. The methodology used needs to be statistically/econometrically accurate, robust and logical.
Practical applicability of the valuation method
A valuation method should be suitable to the type of property and there should be sufficient relevant and reliable data to compute the value estimate. Use of highly advanced valuation models on poor quality data does not help as “the maths may be perfect, but the numerical result may be totally wrong” (Dorchester Jr, 2011: 436). Wyman, Seldin & Worzala (2011: 344) observe that:
The problem in real estate is that there is rarely enough data and the data that is available is not normally distributed so basic statistical models and probability analysis are not necessarily appropriate, although they have been used extensively in real estate research…
Direct primary market research is the best way to obtain information to use for valuation.
Type of property
Income generating properties are investment properties and their values depend upon the potential future cash flows (rental income) they can generate. A discounted cash flow (DCF) valuation method is more appropriate compared to the traditional methods in such cases. As Geltner, Miller, Clayton and Eichholtz (2007) say “…these real estate assets can be compared to, and indeed compete in the capital market with, other forms of capital assets, such as stocks and bonds”. Thus, the valuation method used for income-generating properties should be applicable to stocks and bonds to allow for comparison amongst these capital assets.
Owner-occupied residential properties, on the other hand, do not generate rental income. They only save the owner from paying rent. A sales comparison method would be more applicable for such properties. The DCF would not be applicable as it requires net cash flows to generate a value.
Traditional valuation methods are used for single-tenant, long lease properties where rentals are guaranteed and stable (Baum and Crosby, 2008). This is because the single year rent closely approximates future annual rentals and hence the annual rent can be capitalised to generate a property value estimate (single cap. method). Even for such properties we still recommend a DCF.
Complex, multi-floor properties characterised by multi-tenants, variable occupancy rates and different term-short leases, imply that annual rental income fluctuate. The DCF is the appropriate method to use in such cases as it takes all these factors into account when estimating net cash flows.
Valuation Standards and Principles
The choice of the valuation method should be objective and rational and not based on personal reasons or client influence. Valuation standards and principles should guide one’s work.
Ethical conduct, relevant and accurate research, use of generally accepted valuation principles and standards as well as the ability to draw informed judgements from properly analysed market data make professional valuers (Hanford Jr, 2009; Dorchester Jr, 2011).
List of references
Ambrose, B.W., 1991. An Analysis of the Factors Affecting Light Industrial Valuation, Journal of Real Estate Research, 5(3), pp. 355-370.
Baum, A. and Crosby, N., 2008. Property Investment Appraisal. Great Britain: Blackwell Publishing.
Dorchester, J. Jr., 2011. Market value, fair value, and duress, Journal of Property Investment & Finance, 29(4), pp. 428-447.
Geltner, M.G., Miller, N.G., Clayton, J., and Eichholtz, P., 2007. Commercial Real Estate: Analysis & Investments. USA: Cengage Learning.
Hamilton, T., 2011. Real estate market dynamics during capital market imbalances, Journal of Property Investment & Finance, 29(4), pp. 359-371.
Hanford, L. D. Jr., 2009. Real estate issues: The sales comparison approach to value. MAI.
Wyman, D., Seldin, M., Worzala, E., 2011, A new paradigm for real estate valuation?, Journal of Property Investment & Finance, 29(4), pp. 341-358.