Understanding house valuation

Introduction

Assessing the value of a house is a central task for any actor 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. A valuation is not simply your estate agent telling you the Smiths down the road are trying to sell their house far abovevalue and will never get rid of 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 valuation theory and methodology is not commonplace. There has been little comprehensive literature available as to what constitutes value and what the different methods of determining the worth of a property are. The following article will provide some insight into theoretical approaches to value and valuation methodology.

There are two main theoretical approaches to determining the value of a house, namely the “Comparable Sales Method” and the “Income Approach”. A third method, the “Cost Approach”, will be discussed briefly, but since it is not an autonomous approach, emphasis will be put on the first two methods. The first valuation method focuses on actual market data, whereas the second calculates the profitability of the investment. Since the two approaches complement each other, a diligent valuation will always have to use both.

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.

The appraisal methods discussed below are theoretical approaches to the question of value and help estimate the worth of a property to a buyer or seller. In practice, however, it is the free market, i.e. the forces of supply and demand, which decide what amount of money a house changes hands for.

The US Appraisal Foundation defines market value as:

“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 Methods

The Comparable Sales Method

What is it?

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.

This method works with the market value of homes. It is the most prevalent method in the residential property market, concerning general trends and projections and employing the principle of substitution.

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
Date of transaction, means of payment, transaction speed, etc.

Asset Characteristics
Size, location, conditions, utility, building regulations, business climate, etc.

  • The best way to compare property would obviously be to inspect it in person. Since this option is very time-consuming and not always possible, the next best solution is to search property transaction databases.
  • The simplest way to do the comparison is to assemble the relevant information in graphs. Since there are hardly ever two properties exactly alike, less comparable elements of the data should be eliminated or adjusted in order to ensure accuracy.

Property Transaction Databases

An ideal database will contain information relating to transaction date, price paid, property features and size etc.

  • Land Registry

The best available database is held by the Land Registry. It contains transaction date, price paid, and information about the general property type. The problem with this database is that access is complicated and cost-intensive but hopefully they will iron out these problems soon.

  • Estate Agents

Further sources of data are Estate Agents’ own internal databases which what they have sold. Unfortunately, there is no central repository for this information. Thus, their data is usually concerns only a small proportion of total sales in a particular area. Estate Agents are not always happy to provide complete information and cannot be relied upon for an official valuation. The benefits can be that where available, this data contains rich descriptive information.

  • mouseprice.com

Information on specific transactions is now available to the public through an online service called mouseprice.com. It offers free access to the entries of the Land Registry database.

  • Other Sources

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.

Procedure

  • First, the prospective income and resale value have to be estimated. This appraisal is based on the principle of highest and best use and on comparable data.

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.

  • In order to calculate the present value of a property, prospective future income has to be discounted to reflect the cost of equity capital. This is part of the discounted cash flow (DCF). The opportunity cost of capital can be interpreted as the income that would have otherwise been generated had the capital been invested in an asset of similar risk instead (e.g. an 8% interest rate in a high-yield ISA account).
  • The difficult part in calculating the DCF is how to estimate the risk involved. In property dealings, these estimates are usually based upon historical data on house price volatility. This volatility is broadly in line with the general market volatility and our 8% example as the cost of equity capital can be safely justified.
  • The way to calculate present value (PV) is to divide the future value of a house by (discount rate + 1) no. of years.

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

  • A property also generates income, however. This has to be incorporated into the calculation. A buy-to-let property produces a constant cash flow in the form of rent, whereas if I buy a house to live in myself I increase my income by saving rent.

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.

PV= £2,222

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.

Procedure

  • Estimate the value of the land as if vacant by comparing it to similar properties.
  • Estimate the replacement cost of the building at present. Factors to be considered include site preparation, utilities, types of building materials, tenant improvements and soft costs.
  • Assess the depreciation of the building and deduct the figure from the replacement cost new.
  • Add the estimated worth of the land. The resulting figure is an indication of the value of the property.

Example :
Market value of land: £100,000
Replacement cost of the building: £500,000
Depreciation: £75,000
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 the present 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.

Conclusion

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.

Introduction
Assessing the value of a house is a central task for any actor 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. A valuation is not simply your estate agent telling you the Smiths down the road are trying to sell their house far abovevalue and will never get rid of 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.Introduction
Assessing the value of a house is a central task for any actor 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. A valuation is not simply your estate agent telling you the Smiths down the road are trying to sell their house far abovevalue and will never get rid of 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.Introduction
Assessing the value of a house is a central task for any actor 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. A valuation is not simply your estate agent telling you the Smiths down the road are trying to sell their house far abovevalue and will never get rid of 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.