Valuation methods – property
After inspecting an asset and researching all the factors likely to affect its market value, you should then determine which method is most appropriate for assessing its value.
The three basic valuation methods described below are:
- a direct, sales or market comparison approach
- depreciated replacement cost approach
- income-based approaches.
You should check the valuation you arrive at using the primary approach, by applying another valuation approach.
The first two methods listed above require you to analyse sales.
In deciding whether other sales are comparable, you should consider a range of factors, including:
- the parties to the sales
- the dates of the sales
- any special terms and conditions that applied to the sales.
In the case of real property, you should also consider:
- environmental factors
- utility services
- town planning zoning and restrictions
- site area
- potential for an alternative use
- any other factors likely to affect the property's desirability.
Property markets are diverse. In some instances, there will be sufficient comparable sales to enable a simple valuation. However, generally it will be necessary to analyse recent comparable sales and adjust your initial valuation based on your judgment and expertise.
Analysing a sale
To analyse a sale, you should start by considering the evidence relating to the underlying land value. You may establish the market value of the land component by referring to sales of land with similar characteristics (for example, location, site area, accessibility, services, topography, zoning and potential).
You usually have to reduce the sales evidence to units of value for comparison purposes – for example, dollars per square metre, hectare, square kilometre, unit site or potential block.
Valuers also refer to the 'added value' of improvements. Once you have established the value of the land component, the balance of the sale represents the total value added by the various improvements (such as a house, garage, sheds, paving, fencing and gardens), regardless of the actual cost of each of these improvements.
In some instances, the existing improvements may be redundant because of a potential higher and better use. For example, when existing improvements add little value to the land, and may actually detract from it, because achieving the better potential use may involve costly demolitions.
Depreciated replacement cost approach
'Replacement cost' is also known as the 'summation method'.
After analysing sales to establish land values, you should determine the replacement cost of the existing improvements and allow for any depreciation by age or obsolescence. For instance, you could establish the size of the building (in square metres of floor space), and then calculate a replacement cost in the light of current costs in the area for that type of building. You would then need to deduct a proportion for depreciation, based on local data for the differences between the prices of new and old buildings.
This technique is known as 'depreciated replacement (or reproduction) cost' (DRC), and will result in a market-based assessment.
If you apply the DRC method, the assumptions and depreciation rates you adopt should reflect market rates representative of open market conditions. These rates should not be based on prescribed or arbitrary depreciation rates and asset lives sourced from legislation or guidelines. The DRC should be representative of the market value of the asset, otherwise the valuation would be inconsistent with IVSC and Australian Accounting Standards Board (AASB) standardsExternal Link.
Many properties are valued on the basis of their ability to produce an income stream. This includes commercial, retail, industrial and multi-unit residential properties, and other assets that are purchased for their income-producing capacity and as an investment.
These assets are valued using either the 'capitalisation of net income' or the 'discounted cash flow' (also known as 'net present value') approach.
Capitalisation of net income
Capitalisation of net income is an approach that involves converting the property's income stream into a capital value estimate through a capitalisation process. It uses a single year's income as the basis of the calculation.
A light industrial manufacturer is making a profit or return on capital, after expenses, of $400,000 a year in an industry where the typical rate of return on capital is 23% a year.
To calculate the capitalised value, you invert the rate of return and multiply the profit by that figure:
100/23 x $400,000 = $1,739,130
The multiplier (100/23 in this example) is called the 'year's purchase factor'.
You can vary the final capitalised figure if there are other relevant factors. For example, if a building is vacant at the date of valuation, you could deduct the rental income lost while the property is not leased.
End of example
Discounted cash flow or net present value
The 'discounted cash flow' approach involves applying a discount rate to future cash flows (over many years of income) generated from a property in order to produce a 'net present value'.
If, for instance, you were valuing a business that is likely to produce a profit of $400,000 in each of the next ten years, you would not value the income stream at $4 million. Rather, you would discount the future earnings in order to arrive at the lower 'net present value' of the income stream.
Money you will receive in the future is usually worth less than money you have today. The discount approximates what it would cost you to borrow the money during the period before you actually receive the profit, and it compounds as the future time gets greater.
The net present value of the asset as a whole, represents the amount a hypothetical purchaser would be prepared to pay for the property, based on the discount rate used and the other assumptions adopted in the discounted cash flow assessment.
You need to make appropriate financial allowances, throughout the cash flow period, to account for factors such as capital expenditure, loss of rental income due to expired leases, and acquisition and selling costs.