Estimating the value of a property is necessary for various reasons. These reasons include taxation, property insurance, investment analysis and comparables, sales listing and financing.
However, for the vast majority of people, determining a property’s price is the most useful application of property evaluation.
In this article, you are going to learn the basics of evaluation concepts and property cost evaluation methods. Let’s get started, shall we?
What is property cost evaluation?
Essentially, this refers to the appraisal of a property, both for residential and commercial. Residential property cost evaluations are ideal for people who wish to save money on a full appraisal of their residential property, says Uptown Dallas Properties.
A commercial property cost evaluation is ideal when a loan amount of $250,000 or less is required. Or, for collateral purposes for business loans of $1 million or less.
Basics of Evaluation Concepts
A property appraisal is a process of creating an estimate of value for real estate. Appraisal reports are used when making decisions regarding real estate transactions. They are commonly used by mortgage companies, investors, individuals, government agencies, and businesses.
The goal of an appraisal is to determine the market value of a property.
A property’s value, technically speaking, is defined as the present worth of future benefits arising from the property ownership. The benefits of a property occur over a long period of time. This is in steep contrast to many consumer goods that are used rather quickly.
To estimate the value of the property, several factors have to be considered. They include environmental conditions, government regulations, and economic and social trends. All these factors may affect the four basic elements of value:
Do value, price, or cost mean the same thing? No, apparently, they don’t. Price is the amount that someone pays for something. Cost, on the other hand, refers to the actual expenditures. For instance, on labor or materials.
Although value can get affected by price and cost, they don’t determine value. For example, a house could be priced at $100,000, but its value could vary. If, say, a prospective buyer inspects the house and finds the house is experiencing foundation failure, the value of that house would consequently be lower than the price.
Property Cost Evaluation Methods
- Cost Approach
This is used to determine the construction costs of a property. The cost approach concept assumes that an investor shouldn’t buy a rental property for more than it would cost to reconstruct it.
The cost approach uses the sales comparison approach first to determine the cost of the property. Next, the construction costs are estimated.
It’s worth noting that the cost approach isn’t used for income or residential property real estate. It’s used for properties like hospitals, government buildings, religious institutions, and schools.
Once estimation of the value of land is completed, it's added to the estimated costs of construction. One common way of estimating building costs is by finding the cost of the square foot first. Then, multiply those costs by the total square foot of the comparable.
Next, depreciation costs are subtracted from the summation of land value and construction costs. Three types of depreciation costs exist. They include:
- Economic obsolescence
- Functional obsolescence
- Physical deterioration costs
- Sales Comparison Approach
The sales comparison approach is the most popular of the property valuation methods. It’s also referred to as comparable sales approach or market data. Oftentimes, it’s used for land and residential real estate.
In this method, the cost of the property is determined by comparing that property to similar ones. Typically, three or four properties are used as comparable. For best results, adjustments to the sales prices are made to account for differences in comparable.
An example of such an adjustment is the location. This is because location can have a huge impact on the price of a property. Another good example is the property’s physical aspects. They include the number of bathrooms and bedrooms and the square footage.
- Income Capitalization Approach
Last but not the least is the income capitalization approach. This method is for all income properties such as multifamily homes, commercial real estate, and apartment buildings.
It considers the investment return as well as the property’s net income. It subdivides into two property valuation methods: gross income multipliers and direct capitalization.
Gross income multipliers are calculated by dividing the sales price by the rental income of an income property.
Direct capitalization is calculated by dividing the net operating income of the property by the desired capitalization rate (cap rate).
Accurate property cost evaluation is vital to insurers, investors, mortgage lenders and buyers and sellers of property. If you have specific questions, please seek the advice of a competent real estate agent.