Real Estate Valuation: Part 1 (Cost and Sales Comparison Approach)

Investing in real estate is not a simple decision. It requires mature investment taking capacities. Information inflow in the real estate market is complex. Investing in a company is far easier. Investing in a commercial building, however, has some complex plays in it. Real estate has certain characteristics that make it difficult to simply divide and invest in.

  • Real estate is indivisible and immovable.
  • One piece of real estate is only approximately comparable to another piece of property.
  • Real Estate is illiquid.
  • Lack of an international or national auction market. This makes the property difficult to assess.
  • High transaction costs and management fees.
  • Information about the real estate market is scarce.

To invest in real estate we take the intrinsic value of the property. We appraise a piece of real estate by estimating market value and investment value of a property. The market value estimate is independent, but the investment value of real estate depends on the intended use of the property by the investor. A real estate appraiser uses one or a combination of approaches to arrive at the property’s value.

  • Cost approach
  • Sales Approach
  • Income approach
  • Discounted after-tax cash flow approach

In this article, we take a closer look at the cost and sales comparison approaches:

Cost Approach: In this approach we ask the question what it would cost to replace a building in its current form. This seems a straight forward approach, but has many limitations. The first step is to undertake land valuation, which by itself is not altogether simple. Then we arrive at the cost of construction at current costs. More often than not, a property has other factors that make it more valuable. For instance, a commercial property with stable tenants of reputable brands in a good location can make it a landmark. On the other hand, an expensive to build property in a down market area, with high crime may not be perceived as a good investment.

Sales Comparison Approach: In this approach the value of the property is arrived at by comparing it to a benchmark. The benchmark could be a direct comparison to a similar property. Alternatively it could be the median or average of similar properties in transactions made at the time of appraisal. It is important that the benchmark account for any marked changes in market value of similar properties, correct and appropriate value of the benchmark is used, and it is ascertained that similar properties been sold recently, that provide an accurate benchmark.

When we discuss the sales comparison approach, we need to discuss the hedonic price estimation method as well. The characteristics of the property are identified first. This could include vacancy rate, age of the building, location, amenities, etc. For each property, each characteristic is given a numeric value, usually on a scale. This is done for each property that comprises the benchmark. These values are then regressed on their characteristic values. This results in a single reading for each property on the regression. The dependent variable is the transaction price and the independent variables are ratings for these characteristics. The estimated slope coefficients are the valuation of each characteristic in the transaction price. Therefore, each characteristic value has a corresponding monetary value. In this way a sale price is arrived at by using these characteristic values.

Example Using Hedonic Valuation Approach

Per Square feet, a real estate company follows the hedonic valuation approach to value houses in a specific area. The characteristics of property that affect its prices are listed below:

CharacteristicsUnitsSlope coefficient in pounds per unit
Number of roomsNumber10000
Surface area of the gardenSquare feet10
Swimming pool0 or 110,000
Distance to shopping centermiles-5,000

The company wants to arrive at the valuation of a property that has six rooms, a 3000 square feet garden, a swimming pool and a shopping center that is three miles away from it.

The value of Per Square Feet’s property is therefore:

Value = (10,000 x no. of rooms) + (10 x garden surface) + (10000 x swimming pools) – (5,000 X distance from shopping center)

Value = (10,000 x 6) + (10 x 3000) + (10,000 x 1)– (5000 x 3) = $85,000

The value of this property can be compared to other properties nearby based on the same characteristics.

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