Appraised value vs. sale price Part 2
Last week, contributor Leslie B. Mae tackled this issue, which is of concern to many Jamaicans, and closed with the promise of more on the approaches to arrive at an estimated value of real estate. Here is the rest of the piece.
There are four well-established approaches to arriving at an estimated value of real estate - sales comparison approach, cost approach, discounted cash flow approach, and the direct capitalisation approach - and appraisers usually employ at least two of these approaches in their appraisals.
The sales comparison approach is based on the assumption that properties with the same physical characteristics and in the same general location will sell for the same price. These sales must be at arm's length and under normal market conditions.
In this approach, the appraiser summarises transaction data from comparable properties and makes adjustments for differences in size, age, location, accommodation, and state of repair to arrive at a value. This approach is most suitable for appraising the value of residential properties.
The cost approach requires the appraiser to first estimate the cost of replicating the improvements by using current materials and technology. An amount for depreciation is subtracted from this cost and the value of the land, as if vacant and unimproved, added to arrive at an estimated value.
The fundamental principle of valuation of any financial asset is that its value is the cash flow it generates. Assets with the same stream of cash flows will, therefore, have the same value. This principle can be applied to all financial assets, including bonds, stocks, derivatives, and real estate. When applied to the appraisal of real estate, the principle is referred to as the discounted cash flow approach and is most suited to the valuation of commercial properties.
The process of valuing the property is twofold. First, the cash flow must be determined. Cash flow is the cash received each period from an investment. The estimated cash flow would be the rent received and the expected sale price of the asset at the end of a holding period, usually 10 years.
The next step is to determine the appropriate interest rate for discounting the cash flow. The minimum interest rate an investor would need is the commercial banks' weighted deposit rate.
There are a number of risks associated with realising cash flows, and so the investor would want to add a premium to the weighted deposit rate, depending on the degree of perceived risks.
The estimated value of the property is the sum of the present value of the cash flows generated during the forecast period and the present value of the cash flows generated from the assumed sale of the property.
The direct capitalisation approach is based on the net operating income (NOI) of the subject property. Appraisers generally consider an NOI-based approach to be the most valid for estimating market value of income-producing properties, which are bought and sold based on their actual earnings or earnings potential.
The NOI is calculated by subtracting from the total potential income, vacancy allowance, fixed variable cash operating expenses (not including debt servicing), and tenants' incentives.
The estimate of value is then determined by dividing the NOI by a rate of return known as the capitalisation rate (Cap Rate). The Cap Rate is usually set by the market.
The implication of the fundamental principle of valuation on real estate is dependent on the effect of market forces on the net operating income of the asset. The price of a real estate asset is a function of net operating income and is influenced by supply and demand factors.
Demand factors include mortgage rates, which affect affordability; general economic conditions, which affect businesses and their need for space; and demographic changes.
Supply factors include cost and availability of financing; expected future demand; and changes in public policy, for example, taxation.
A clear distinction must be made between appraised value and sale price. Appraised value is an opinion of value given by an appraiser as to the most likely price that a willing buyer will pay in a normal market situation.
Sale price is the actual price a purchaser pays for acquiring real estate. According to the Valuation Analysis for Home Mortgage Insurance (1990), knowledgeable buyers and sellers in the market examine and view available properties in terms of the probable future benefits to be derived from ownership.
Their expectation or their forecasts with respect to the extent, quality, and duration of the benefits are translated into present prices. Buying and selling with these considerations in mind create real estate price levels.
Keep sending your questions and comments and let's continue to explore A Matter of Land. Until next time, traverse well.
- Craig Francis is a commissioned land surveyor and managing director of Precision Surveying Services Ltd. He can be contacted at email@example.com or his Facebook page Precision Surveying Services.