Assessing the value of a house is a central task for any seller or buyer in the property market. Sellers base their asking price on the valuation, while property buyers need to decide whether a certain real estate is worth its price and, if not, how much to offer for it. Appraising the value of a property is a complex issue where many factors have to be taken into account – it is a combination of art and science.
The Faults of Estate Agents’ Valuations - Independent property valuations are only performed by chartered surveyors. It is a common misconception that Estate Agents value your property for you. Agents simply guide you to a suggested asking price – they cannot be relied upon to provide objective and accurate valuations.
The asking price an Estate Agent recommends is often over-inflated because of their desire to appease the seller in order to win an instruction. On the other hand Estate Agents may encourage a seller to accept a below-market offer in order to secure a quick sale. Their motivation lies in the fact that, despite being paid a percentage based commission, Estate Agents make more money by turning over properties quickly than they do by holding out for a higher price.
DIY Valuation - It is perfectly possible for non-professionals to do their own valuations. Unfortunately, a thorough understanding of process is not commonplace. There has been limited information as to what constitute value and what the different methods of determining the worth of a property are.
Value - Value is, of course, a subjective rather than an objective term. A property might be more valuable to one person than to another, because that person values certain features higher than the other or because the property has a higher utility to one person than to another. The forces influencing the value of property include its environmental and physical characteristics, social standards, economic influences and political or government regulations.
It is therefore imperative that the most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus.”
There may be a substantial gap between subjective valuations and the fluctuations of the free market. Thus, the value of a property does not always correspond to its price. The forces of supply and demand cannot be scientifically predicted. Every property valuation can only ever be a guideline to what the house will eventually change hands for.
The different methods of valuating a property:-
The Comparable Sales Method - The “Comparable Sales Method” is also called “Inferred Analysis” of property value. This method estimates the value of a house by comparing it to the prices of similar property sold in similar locations within a recent period of time. The basic assumption is therefore that a property is worth what it will sell for, in the absence of undue stress and if reasonable time is given.
Procedure - The central task is to systematically assemble data on comparable properties. Basically, the forces influencing value have to be weighed against each other. The relevant elements to look for can be split up in transaction and asset characteristics:.
Transaction characteristics being date of transaction, means of payment, transaction speed etc, and asset characteristics relates to size, location, conditions, utility, building regulations, business climate. Etc.
Property Transaction Databases
An ideal database will contain information relating to transaction date, price paid, property features and size etc.
Information on specific transactions is now available to the public through an online service called www.mouseprice.com. It offers free access to the entries of the Land Registry database.
A company called Hometrack sell individual property price reports. However in the past we have found their reports to be of limited use because the comparable property transaction data they provide does not always mention specific property addresses, transaction dates, or actual sales prices – all of which are crucial valuation information.
Advantages & Disadvantages
+ It is the most straightforward method and general practice, especially in the residential housing market
+ As a theoretical approach it most closely reflects the actual market value of a property, therefore its objective value
- Sometimes it might be difficult to locate enough similar, recently sold properties
- Market value and price might differ due to “unreasonable” actions by other actors
- This technique makes no reference to intrinsic value. If a property’s price is reasonable on a comparable basis, it does not entail that it is a reasonable price for an individual, both to sell or to buy.
Example : I might want to purchase a property in order to let it. The property’s price might be within a reasonable market price range, but because average rents in the area are not very high the investment would not be profitable to me.
The Income Approach
What is it?
The “Income Approach” is also termed the fundamental or intrinsic method of property valuation. In this method,the present worth of a property is estimated on the grounds of projected future net income (in rent, for example) and resale value.
The method uses the discounted cash flow (DCF) model to determine the present value of an investment. One underlying assumption of this approach is the principle of opportunity cost of capital, i.e. that money is of more value to its holder today than in the future.
The principle of anticipation is fundamental to this approach. It states that value can be created today by expected future profits.
Although complex, this method is an essential element to the valuation of any property; it is almost always employed by financial and investment professionals when valuing assets.
Example : A three-bedroom flat is bought to let. Historical data shows that I can expect a 50% increase in market value within 10 years. Market analysis tells me that the average rent of comparable properties in a similar location is £4000 per annum.
Example : A three-bedroom flat costs £120,000. I expect to be able to sell it for £180,000 in 10 years. I set my discount rate at 8%. The calculation looks like this:
PV = £180,000 / (1 + 0.08)¹º = £83,375
Example : The three-bedroom flat generating £4,000 per year in rent costs £1,600 in expenses. That means I have an annual income of £2,400. I set my discount rate at 8%. The calculation for the net present value of the first year’s income is:
PV = £2,400 / (1+0.08) 1.
It results that the present value of my net income in year 1 is £2,222.
Yet, I do not plan to resell my flat after one year, but keep it for at least 10 years. In that case the calculation goes as follows:
PV = (£2,400 / 1.08) + (£2,400 / 1.08²) + (£2,400 / 1.08³) + … +(£2,400 / 1.08¹º) =
= £2,222 + £2,058 + £1,905 + £1,764 + £1,633 + £1,512 + £1,400 + £1,296 + £1,200 + £1,112 = £16,102
The results, based on our assumptions, show that the present-day value of the three-bedroom flat is
£83,375 + £16,102 = £ 99,477
I would therefore be ill-advised to buy the flat at the current price of £120,000.
The valuation that this method generates is highly sensitive to the following variable assumptions:
Rental Net Income – £ 2,400
Resale Value – £180,000
Discount Rate – 8%
These assumptions dictate the value an individual will place on a property.
Advantages & Disadvantages
+ Focuses directly on the value of the property to the individual concerned
+ Income analyses are very detailed and derive specific conclusions (in contrast to the more general approach practiced in the sales-comparison method)
- This method is more complex and less intuitive than the comparable sales method. This is one of the reasons why it is often overlooked.
- Ignores the actual market prices for property by neglecting the comparable sales analysis
The Cost Approach
What is it?
The cost approach estimates the replacement value of a property by analyzing the cost of its components, i.e. land and building. It lies somewhere between the inferred and the intrinsic method, and is not a fully autonomous valuation method.
Value is calculated by adding the free market value of the land as if vacant to the reconstruction cost of the building, minus depreciation suffered over the years in comparison to a new building.
Market value of land: £100,000
Replacement cost of the building: £500,000
Value of property: £525,000
Advantages & Disadvantages
+ Sets the value at the actual cost or price of the property
- Relies upon other valuation methods to derive the value of the land
- Neglects the difference between cost and value, namely that one property might be cheaper than another but generate a much higher net income
Summary of the Methods
The“ Comparable Sales Method”focuses on market data of sales of similar property in a recent time period and thus gives and estimate of which price is adequate for a certain kind of property. Sales comparisons can easily be performed using internet databases of property transactions. The advantage of this method is that it reflects the actual market prices, but it neglects the aspect whether a property investment is profitable for seller and buyer, or not.
The “ Income Approach” concentrates on the profitability of a property investment. It analyses thepresent worth of projected future net income and anticipated future resale value. This method gives a good appraisal of whether a certain property is worth its price to the buyer, but it neglects the relation to the overall market.
The “ Cost Approach” lies somewhere between the two previous methods and is not actually an autonomous technique of value analysis. It estimates property value by adding the cost of the land to the replacement cost of the building minus depreciation, thus coming up with a figure of how much the property should be worth.
In order to get a good estimate of value for a property it is necessary to employ both the sales-comparison and the income approach.
It should be clear by now that there is no perfect method of assessing the value of a property – an appraisal is an art as much as a science, and in the end it is supply and demand which determine the actual price of a house.
Yet at the same time, the methods discussed above provide guidelines to both buyers and sellers on how to estimate the approximate worth of a house. This helps sellers decide where to set the price for their property and provides buyers with means of evaluating where a house is located in the market and whether it is worth the investment. In the end, both the sales-comparison and the income techniques have to be used to get a valuable estimate of property value.
The principle of substitution says that value will usually be set by the cost of acquiring an equally desirable substitute on the market.