Real Estate Valuation: The Three Approaches
There are three common real estate valuation approaches as described below:
1. Sales Comparison Approach: An estimate of value based on similar properties recently sold. Since no two properties are exactly alike, this valuation approach benchmarks comparable properties and adjusts for differences such as size, time, and amenities. The more comparable sales available, the stronger the estimate of value.
2. Cost Approach: An estimate of value based on the cost to replace or rebuild the property. This valuation approach assumes a buyer would not pay more for a property than the cost to build a substitute. It is very useful for unique (special-use) properties or when there are few comparable sales available. This valuation approach is generally believed to be less reliable for older construction.
3. Income Capitalization Approach: An estimate of value based on converting an income stream using an expected rate of return required by investors. It is calculated by dividing Net Operating Income (NOI) by the Capitalization Rate (Cap Rate) for recently sold comparable properties in the area.
For example, if a property’s NOI is $100,000 and the Cap Rate for recently sold comparable properties in the area is determined to be 8%, then the estimate of value using the Income Capitalization Approach is $1,250,000. ($100,000 / 8%)
Capitalization Rate (Cap Rate): The Cap Rate is an expected rate of return required by investors of a property over a one-year period. It is calculated by dividing NOI by the sales price of recently sold comparable properties in the area. Cap Rates have an inverse relationship to value so a lower rate results in a higher value. Also, while Cap Rates are very useful for quick investment analysis purposes, it’s important to remember that they do not account for various items such as future cash flows from improvements, time value of money, depreciation, debt service, or income taxes. For a more detailed assessment, a Discounted Cash Flow Analysis is a preferred method to incorporate these additional factors.
Net Operating Income (NOI): As outlined in a previous post, NOI is the total of all income from the annual operation of the property after deducting operating expenses and is calculated by subtracting Total Operating Expenses from Gross Operating Income (GOI).