3 Approaches to Property Valuation

In order to finance the acquisition of real estate (or refinance), lenders will require that an appraisal be conducted. This process determines the market value of the property based on its highest and best use. Because the real estate acts as the collateral securing the loan, this metric establishes the maximum amount a lender is willing to loan to a buyer. Here are the 3 main approaches used by appraisers to determine value:

  1. Sales Comparison Approach – This approach is based primarily on the principle of substitution. While no two properties are exactly alike, there are a number of techniques to adjust for differences in comparable properties, which either increase or decrease the value of the subject property. The greater the number of available comps to measure against, the greater the validity of the comparisons; resulting in more accurate estimate of value.
  2. Cost Approach – This approach estimates value by summing the land value and the depreciated value of any improvements. Adjustments are made based on 3 forms of depreciation: physical deterioration (physical wear and tear from use), functional obsolescence (decline in utility caused by changes in design and use preferences), and external obsolescence (decrease in value from declining neighborhood or general market conditions). The cost approach is most used for special-purpose buildings and when few market sales comps are available. The cost approach uses 4 steps:
    1. Estimate the value of the site (vacant and in its highest and best use)
    2. Estimate the cost to reproduce the existing building
    3. Estimate the amount of accrued depreciation and deduct that amount from the cost to reproduce the existing building
    4. Add the site value to the cost to reproduce the existing building minus depreciation
  3. Income Capitalization Approach – This approach analyzes the income stream of a property to estimate value and is used primarily in commercial and investment property appraisals. The 2 primary methods to calculate value under this approach are the direct capitalization method and the discounted cash flow method. The direct capitalization method estimates value by dividing the net operating income for year 1 by the appropriate market capitalization rate. The discounted cash flow method, on the other hand, estimates value based on the present value of multiple years of income using a market discount rate.



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