Real Estate Valuation Methodologies

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INTRODUCTION
Value is a subjective rather than an objective term. A property might be more valuable to one person than to another, because different people may derive different utility from the same property. The forces influencing the value of a property include its environmental and physical characteristics, social standards, economic influences and political or government regulations

Then houses are both durable goods and tradable assets. They provide a flow of rents to the owner, or housing services to the occupier, and there is an active secondary market in which houses can be bought and sold. But the price of the housing is harder to measure than most of goods and assets due to the following reasons: 1) Dwellings are Heterogeneous. No two dwellings are exactly identical, as they cannot occupy the same location. 2) Transaction price is reached through negotiation and auctions so advertised price is not a correct indication of the actual price. 3) Lastly houses are sold infrequently so the recent price observation can act as a poor guide for the latest transaction REAL ESTATE PROPERTY VALUATION Real Estate valuation is a service provided by licensed or certified appraiser, who gives an opinion of value based on the highest and best use of the real property. The highest and best use is that use which produces the highest value for the land, as if vacant. This use is based on 4 parts; physically possible, appropriate, legal, and economically feasible. Types of value: Market Value- The price at which an asset would trade in a competitive setting Market Value is the estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arms-length transaction after proper marketing wherein the parties had each acted knowledgably, prudently, and without compulsion.(IVS 1 - Market Value Basis of Valuation, Seventh Edition) Value-in-use The net present value (NPV) of a cash flow that an asset generates for a specific owner under a specific use. Value-in-use is the value to one particular user, which may be above or below the market value of a property. Investment value - is the value to one particular investor, which may be above or below the market value of a property. Insurable value - is the value of real property covered by an insurance policy. Generally it does not include the site value

VALUATION METHODS FOR REAL ESTATE PROPERTY

1) Income Method The Income Method is the Fundamental or the Intrinsic method of property valuation. The present value of the property is estimated based on the projected future net income and re sale 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. 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. The Income approach capitalizes an income stream into a present value. Using Revenue multipliers or single-year capitalization rates of Net Operating Income (NOI). NOI = Gross Potential Income (GOI) Vacancy Operating Expenses. Procedure: Central to this valuation method are the various assumptions that are to be made for the DCF analysis- the future income, re sale value and the opportunity cost of capital. For the income based valuation of real estate, first the assumptions are made. Next a DCF analysis is done. The PV of the property consists of two parts: The annual income generated The re sale value The annual income for each year and the re sale value are projected. Using the opportunity cost of capital, the present value is determined. This PV is the Income based value of the property.

Example of Income Method: Calculation of Sale PV ( Present Value ) The three-bedroom flat costs Rs 120,00,000. The expected Resale value is for Rs 180,00,000 in 10 years. Let the discount rate be 8%. Then

Sale PV = Rs180,00,000 / (1 + 0.08) = Rs 83,37,500 Calcuation of Income PV ( Present Value ) The three-bedroom flat generating Rs 4,00,000 per year in rent costs Rs1,60,000 in expenses. So annual income is Rs 2,40,000. Let the discount rate be 8%. The calculation for the net present value of the first year's income is: Income PV = Rs 2,40,000 / (1 + 0.08)= Rs 2,22,200 The present value of the net income in year 1 is Rs 2,22,200. Assuming that the flat is not re-sold after one year; instead, it is kept for 10 years. In that case: Income PV = (Rs 2,40,000 / 1.08) + (Rs 2,40,000 / 1.08) + (Rs 2,40,000 / 1.08) + ... etc ... + (Rs 2,40,000 / 1.08) Income PV = Rs 16,10,200 The results, based on the assumptions, imply that the present-day value of the three-bedroom flat is: PV = Sale PV + Income PV PV = Rs 83,37,500 + Rs 16,10,200 PV = Rs 99,47,700 Hence the flat should not be bought at the current price of Rs 120,00,000. It is worth noting that this valuation method generates a result that is highly sensitive to the following variable assumptions: Rental Net Income: Rs 2,40,000 Resale Value in 10 years: Rs 180,00,000 Discount Rate: 8% These assumptions dictate the intrinsic value placed on a property. Advantages: It focuses on the value of the property to the individual concerned Income analysis is very detailed and draw specific conclusions

Disadvantages: More complex and less intuitive than the sales comparable method It ignores the actual market prices for property by neglecting the sales comparable method The ultimate value is highly sensitive to the assumptions made

2) The Cost Approach The cost approach was formerly called the Summation approach. The value of a propert can be estimated by summing the land value and the depreciated value of any improvements done on it. It is the land value, plus the cost to reconstruct any improvements less the depreciation of these improvements. The overall methodology is a hybrid of cost and the market data approaches. As the cost to construct a building can be determined by adding the labor and materials cost together but land values and depreciation have to be gathered from market data. This is most reliable when used on newer structures. This method estimates the replacement value of the property by analyzing the cost of its components- land and building. It is mid way between inferred and intrinsic methods. Free market value of the land as if vacant + reconstruction cost of building Depreciation suffered over the years = Value based on cost approach Procedure: The value of the land as if it was vacant is estimated. The second step is to estimate the replacement cost of the building keeping in mind factors like utilities, building improvements, tenant improvements, soft costs etc. Next, the depreciation amount is assessed and deducted. Then add the estimated worth of land and the figure so obtained is the value of the real estate based on the cost approach. Example: Market value of land: Rs10,00,000 Replacement cost of the building: Rs 20,00,000 Depreciation: Rs 7,50,000 Value of property = 10,00,000 + 20,00,000 -7,50,000 = 32,50,000 Advantages and Disadvantages: This method sets the value at the actual cost or price of the property, however it relies upon other valuation methods to derive the value of the land. Furthermore, it neglects the

difference between cost and value, namely that one property might be cheaper than another but generate a much higher net income.

3) The Comparable Sales method Also called the Inferred Analysis method of property valuation, it estimates the value of a house by comparing it to the prices of similar properties 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. It is the most prevalent method in the residential property market, concerning general trends and projections and employing the principle of substitution. This approach looks at the price or price per unit area of similar properties being sold in the marketplace. The sales of properties similar to the subject are analyzed and the sale prices adjusted to account for differences in the comparables to the subject to determine the fair market value of the subject. This approach is generally considered the most reliable, if good comparable sales exist and can serve as an independent check on the reasonability of a valuation opinion. Procedure: The most important task is to systematically assemble data on comparable properties. The relevant characters to be looked for can be split into transaction and asset characteristics: Transaction Characteristics - Date of transaction, means of payment, transaction speed, etc. Asset Characteristics - Size, location, conditions, utility, building regulations, business climate, etc. Ideally, a property should be inspected in person. But considering the paucity of time, property transaction databases are used. Once, all the data is gathered, the next task is to draw informed conclusions. This is done by assigning weights to the properties. The ones closer to the property to be examined are given higher weights. Important Considerations while comparing: When selecting properties that you consider comparable to your subject property, important considerations include: Statistically, sales far above or far below the bulk of the group are suspect. There likely are valid reasons for the divergence.

 Comparable properties should be from the subject property's area or as close as possible. Sold comparables should not be too old and should be in the current time frame as far as possible. Similar construction types should be used. Adjustment of Value for Property Differences: When comparing similar properties, there will always be differences. Property's value estimate should be adjusted for its differences from the comparable properties: Add or subtract value for difference in lot or acreage size. Feature differences, such as bedrooms, baths, garage, etc should also be considered. Financing differences could have also influenced the sale price.

Advantages: Most easy and straight forward method. It has thus become the practice in residential housing market. Leads to an objective valuation being placed on the property.

Disadvantages Sometimes it becomes difficult to locate enough similar property transactions to draw meaningful conclusions. Market value and price might differ due to unreasonable actions by others. This technique makes no reference to intrinsic value. If a property's price is reasonable on a comparable basis, it does not necessarily follow that this is a reasonable buying or selling price for an individual

4) Automated valuation models Automated valuation models (AVMs) are growing in acceptance. These rely on statistical models such as multiple regression analysis and geographic information systems (GIS). While AVMs can be quite accurate, particularly when used in a very homogeneous area, there is also evidence that AVMs are not accurate in other instances such as when they are used in rural areas, or when the appraised property does not conform well to the neighborhood. Extreme caution should be exercised when relying on AVMs, especially if the user is unfamiliar with modeling and the mathematics. Strengths and Weaknesses of AVMs The strengths of AVMs relative to traditional real estate appraisals are speed, reduced costs, consistency, and objectivity. An AVM can significantly reduce the time it takes to obtain an estimate of value and reduce the costs associated with the traditional property valuation. However AVMs have three principal limitations:

First, they are dependent upon the accuracy, comprehensiveness, and timeliness of the data they use. Data issues can include incomplete public records, insufficient sales of properties with comparable features within a specified geographic area, and a lag between the time when the market data are current and the AVM uses the data to generate an estimate of value. Second, AVMs cannot be used to determine the physical condition and relative marketability of a property. Third, AVMs can never fully incorporate the breadth of knowledge and judgment of a skilled appraiser.

Consequently, AVMs tend to work best in circumstances when there is a relative abundance of current data, when properties in a given area are relatively homogenous, and when a property's condition and marketability are relatively typical for the area. They work less well when data are thin, in heterogeneous neighborhoods, and for properties that differ markedly from the average property condition or marketability.

VALUATION FOR REAL ESTATE COMPANIES Net Asset Value (NAV) methodology is the most suitable for valuing real estate companies. They should be valued by discounting the post-tax cash flows from all its development segments at an appropriate discount rate and arrive at an NAV estimate. Changes in property prices and construction costs are the key risks to our valuation. 1) Earnings based valuations Profits from real estate development comprise two components pure development margins and profits from appreciation in the value of the land. Land profits are nonrecurring in nature; on a sustainable basis, developers are more likely to earn development margins only. Assigning a multiple to such non-recurring profits is likely to distort the valuation of a developer significantly. Consequently, valuing a real estate company on the basis of earnings based multiple is not the most appropriate method. 2) Valuation of land banks Assessing land banks is another method of valuing real estate companies. However, the developer is likely to develop his land bank over a period of time, and the time value of these cash flows is ignored by the land bank valuation methodology. This is especially true in cases of companies with large land banks, which would not likely be absorbed in a few years time and could take longer to develop. Moreover, land bank valuations ignore the crucial aspects of taxation and future land payments. 3) NAV the most appropriate valuation tool The valuation of the Properties has been undertaken on the basis of the discounted cash flow approach (income approach) to valuation. This approach is based on the premise that the value of an income-producing asset is a function of future benefits and income that can be derived from the same. The future cash flows from the Valued Properties are forecast using precisely stated assumptions, together with the estimated capital value of the building(s) upon a deemed disposition at the end of a holding period. This method allows for the explicit modeling of income associated with the property. These future financial benefits then are discounted to a present day value at an appropriate discount rate. This method has the following advantages: Given that large land banks would typically be developed over a period of time, the cash flows from development are appropriately discounted to take into account the time value of money. The NAV method is suitable for developers with a mix of residential, commercial and retail projects, as all of these have very different cash flow timings. Discounting cash flows is suitable for SEZ projects given that these are longterm in nature.

The likely challenge in valuing real estate companies would be the difficulty in determining and estimating property prices. Indias property markets are undeveloped and lack transparency. Moreover, there are different micro-markets within cities and regions, each with its own demand-supply and price dynamics, which makes price determination all the more difficult.

Method

Advantages Simple to use Easy to understand

Disadvantages Assigns multiple to nonrecurring profits from land bank appreciation. Overstates value Assumes consistent growth in land prices in the future

Earnings based valuation

Simple to use Land bank valuations Popular with property consultants

Ignores critical elements such as: Taxation Future land payments Time value of money

Accounts for time value of Requires detailed money, since large land calculations banks would be developed over a number of years Suitable for developers with a mix of projects with differing cash flow timings Suitable for SEZs given their long gestation periods Allows analysis of land price sensitivity

NAV using DCF

The Valuation by property consultants is based on the following assumptions, which enable them to give the Opinion of Value, are: (a) There is a willing buyer and seller of each Valued Property. (b) That prior to the date of valuation, there had been a reasonable period for the proper marketing of the interest in each Valued Property, for the agreement of price and terms and for the completion of the sale. (c) The state of the market, level of value and other circumstances were, on any earlier assumed date of exchange of contracts, the same as on the date of valuation. (d) No account is taken of any additional bid by a purchaser with a special interest in the Valued Property. (e) Both parties to the transaction had acted knowledgeably, prudently and without compulsion. The valuation for three types of properties held by Real Estate companies are done as follows: 1. Completed Projects Market approach for valuation is used for completed projects. A comparison is made for the purpose of valuation with similar properties that have recently been sold or available for sale in the market. Value of the property is worked out after deducting brokerage cost from the sale value. Brokerage cost is estimated at percentage of sale value. 2. Under Construction Projects Value of the under construction project (likely to be completed in a years time) is worked out after deducting balance cost of construction and brokerage cost from estimated sale value. Balance cost of construction is worked out on the basis of incomplete percentage of construction work as per the information provided by the Company. 3. Upcoming Projects Value of the property is its land value. Discounted Cash Flow (DCF) method is used to arrive at property value. The DCF methods determine the present value of future cash flows by discounting them using the appropriate WACC (Weighted Average Cost of Capital). Net cash flow is arrived after deducing cash outflows (land development cost, cost of construction, brokerage cost, etc) from cash inflow (realizable from sale). Capitalizing net cash flow at WACC gives value of property. WACC is a function of the cost of equity, the cost of debt and debt equity ratio.

Conclusion Real estate Valuation is primarily done by three methods- the income method, cost method and sales comparable method. The income method uses the DCF valuation method, the cost method uses the estimated replacement cost, and the sales comparison method compares property transactions of similar properties in the near past. Also, methods like AMV which are based on statistical techniques are gaining importance. The valuation of real estate companies has also been discussed. References 1. www.economictimes.com 2. www.navigantcapitaladvisors.com 3. www.efanniemae.com 4. www.appraisalinstitute.org 5. http://www.thehindu.com 6. www.iloveindia.com/real-estate/property-valuation.html 7. www.about.com 8. REAL ESTATE VALUATION IN TRANSITION ECONOMIES by Dr. Nikolai TRIFONOV 9. Real Esate Sector report by SSKI 10. Property Valuation Standards Update , Fannie Mae 11. Econometric Solutions for Real Estate Valuation Automated Valuation Models Friend or Foe? By Eugene Pasymowski, MAI 12. The measurement of house prices By Gregory Thwaites and Rob Wood