How Does Real Estate Valuation Work?

Posted by Team - 30 January, 2013


real estate valuationThe best approach to valuing real estate is to hire a real estate appraiser. Appraisers have a method to determine the best and closest fair market value of real estate property. One of their three approaches will be the right one for your property:

     •   The Income Approach

     •   The Market Data or Comparable Sales Approach

     •   The Cost or Replacement Value Approach

Each approach looks at property from a unique angle and with a completely different viewpoint on best use.

Approach the Property

The Market Data or Comparable Sales Approach is the only method to determine the price of a home for sale. The Income Approach is useful in determining the value of income-producing property. Cost or Replacement Value Approach is for insuring a piece of property.

If the property earns an income for the owner, valuation results from using the Income Approach. A private home serving as a residence will derive valuation from the Market Data or Comparable Sales Approach. When the owner is purchasing insurance for a piece of property, the insurance company will use Cost or Replacement Value Approach to determine value.

Income Approach Calculations

Determining the fair market value of a property that produces income for the owner rests on the rate of return that the property provides. Part of this calculation involves the net operating income and the actual price of the property. If an appraiser has two of these three factors, certain calculations will help determine the last one.

The formula reads thus:  

The Net Operating Income divided by Desirable Capitalization Rate (Rate of Return) will equal the Property Value.

In this case, the value of the real estate depends upon the income it is able to produce. If there is no income, this property is worthless and the Income Approach could not determine value.

Fair Market Value Data Approach

A real estate broker would use this process to determine the listing price of a home for sale in relation to other homes in the area of the same design and style. It is necessary to make a list of similar homes in close proximity to the subject property. The sale of these homes should not be more than twelve months ago.

Similarities between the subject property and the comparables should include:

•        Close geographic locations

•        Approximately equal square footage

•        Similar amenities

•        Similar style and approximate build dates

•        Equal maintenance, upkeep and lot size

These five points are especially important in a real estate market featuring much fluctuation.

Condominiums within complexes have a slightly different treatment under this approach. Each unit within the complex has its own total square footage of living space. Altogether, units within a building should equal the total square footage of the building itself.

A search of the geographic area should reveal another complex that is similar in size and structure. It should have changed ownership recently so that the total price paid for the complex, divided by the size of each unit should render the price of each unit. The same calculation will apply to the comparison of one unit from each complex.

Cost or Replacement Property Insurance

This approach gives an estimate of the value of property if that property would need replacement in its entirety. Several facets comprise the Cost or Replacement Value estimate. It begins at the start with a determination of the cost to buy the piece of land and build a structure identical to the one needing replacement.  

Calculations must include the following:

     1) Determination of land value at the time of calculation

     2) Determination of land improvements including lawn, shrubs, walkways and trees at current costs

     3) Determine the cost of duplicating the exact building at current cost per square foot

     4) Include subtraction of a predetermined percentage of the building cost for depreciation – approximately 20% is common


One of three approaches to real estate valuation is appropriate for any property. Use of the property determines the method an appraiser chooses. Two approaches determine the value of a property when it is for sale. The third process is to determine how much insurance the owner must carry on the property.

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Topics: Real Estate, Finance

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