Valuation is at the heart of real estate investment without which no strategic planning is possible. In our two part series, we will present two essential valuation methods for investment purpose. However, before we dive in we start with an important caveat. Any valuation should be used in conjunction with separate local market analysis. As we will see, the assumption used in the valuation process depends crucially on this understanding of the market place. The main thrust of this piece is to provide a quantitative approach to valuation that augments and supplements additional market research.

Basics of Valuation

Valuation is the determination of the feasible price any property should bring in a competitive and open market under all conditions requisite for fair sale. This implies: (a) Buyers and sellers are striving towards getting the best bargain, (b) Buyers are sellers are well informed about the real estate market.

Reasons for Valuation

• Negotiation with seller: An accurate and proper valuation is essential for the negotiation process with the seller
  
• Investment feasibility analysis : A key aspect of the invest feasibility analysis is to obtain a proper valuation (thus an estimate of initial investment necessary)
  
• Debt financing: because most of the real estate investment involves some form of debt financing. As an investor you should be aware of established valuation techniques so that your valuation is consistent with that of the lenders
  
• Other reasons: The other reason for valuation is for insurance purposes and property tax assessment.

Valuation Steps

• Physical and Legal identification: This is especially important in Indian market where the local variation of rules can create problems later on. So this step is an important first step.
  
• Specify the purpose of valuation : See above
  
• Specify effective date of value estimation:We all know that market conditions are fluid, so every valuation has an expiration date attached to it. Moreover, a longer valuation horizon needs to take into consideration the unknown risk factors.
  
• Gather and analyze market data: This is the most important aspect of valuation. All valuation is based on assumptions, and good valuation is based on assumptions that accurately reflect the reality of the market place. Example of market data includes rent information, vacancy rates, supply and demand factors, absorption rate in the neighbor hood etc.
  
• Use valuation methods: Once armed with appropriate data, it is time to crank the valuation machine. The reason we discuss alternative valuation methods because each will provide a glimpse of a different aspect of the inherent value of the property.

Valuation Method:

We consider two popular valuation methods that reflect different approaches to valuation. We elaborate each of this approach and highlight their strength and weakness. In the first part of the series we will discuss about the Sales comparison approach and the second and third  part will cover the income approach.

Sales comparison approach

1. Methodology Overview:  Simply speaking, the fundamental premise of this approach is that the value of a property should be closely comparable to similar properties sold recently. While it looks deceptively simple, the key word is similar properties. In real world it is sometimes difficult to come up with a sample of sold properties which has exactly identical characteristics, in this case we do suitable adjustment such that the properties are comparable to the property to be valued (our example below will make the mechanism of adjustment clear).
   
   As a first step we define the characteristics and necessary adjustment required. We will like to add that while we provide general guidance here, additional characteristics need to be taken into consideration based on the uniqueness of the property. If you need valuation assistance for specific properties then our experts at sales@residencebuy.com   are at your service to lend a helping hand. 
   
2. Factors for defining Similarity:  Following are few important factors of interest: 
   
   • Closeness to Subject property: This is the most important factor of consideration.Ideally the comparable property should be nearby or “functionally” close (what we mean by “functionally close” is that the properties may be geographically far but similar in functionally; i.e. two rental properties geographically apart but in posh neighborhood, say Friend’s colony and Vasant Kunj in New Delhi). Proper adjustment need to be done for proximity if necessary.
     
   • Date of Sale : The comparable properties should have been sold in the recent past. If it is further back in the past then one has to incorporate market price trend to get an estimate of the current sale price. For example if the property price appreciates at 3% per annum in the last two years and the property under consideration was sold 2 years back then we need to do a 6% positive price adjustment for the purpose of comparison.
     
   • Age of property: If the comparable property is older than the subject then necessary discounting needs to be done.
     
   • Construction quality : If there is a significant difference in construction quality then a suitable adjustment needs to be done to account for this difference.
     
   • Ancillary facilities: This includes other relevant factors like number of floors, existence of elevator, aesthetic factors (proximity to park or gorgeous view etc), and landscaping to name only few. Here several qualitative subjective judgments need to be carried out to bring the comparable property in par with the subject property.
     
     We reiterate that the above list is by no means exhaustive and our advice is to prepare the comparable list based on the uniqueness of the property under consideration.
     
3. Derive the Value of the property : Commonly two methods are used for the valuation purpose which we briefly describe below.
   
   • Price per unit area adjustment : Here we adjust the price per unit area (say, square ft.) to account for difference in “similarity” dimensions referred to above. After adjusting the known price per unit area for comparable properties we aggregate this figure to derive the price per unit area for the subject property. A simple approach is to just take the average of adjusted price per sq. ft for the comparable properties. The final value is then determined by simply multiplying the area with the price per unit area.
     
   • Rental Income to Sales price comparison: This approach is similar to Income Approach in spirit which we will be covering in details in the second part of this series. To give you a quick peek, this approach aggregates the ratio of rental income to sales price of comparable properties with suitable adjustment based on “similarity” factors and apply the same to the property under valuation.
     
4. Let’s Go to Valuation Lab:
   
   We have introduced a lot of concept above so we demonstrate the usage below based on Price per unit area adjustment approach. We will discuss about the assumptions as we go along. In this example we consider the valuation of a mall complex and consider three similar complexes that were sold earlier. Note that the adjustment factor is applied to the price per gross sq. footage. Raw price per square ft. is derived by simply dividing the sale price by gross sq. footage (e.g. for property 2, it is Rs.60 Crores /20,000= Rs. 30,000). As you can see from the top panel of the tables given below the “similarity factors” (fields highlighted pink) are not exactly identical, thus we need to do the relevant adjustment to derive the subject property price per sq. ft.
   
   • Adjustment Assumptions: Fields highlighted pink are “similarity factor” alluded to above. If there is difference in these characteristics then suitable adjustments is made to price per sq. ft based on the following assumptions:
     • Price appreciation per year is 5%, thus a property sold 1 year back has an adjustment of +5%.
     • The subject property is in a very good locality, thus moving away from it leads to a drop in valuation of the property( 0.5% per km. distance)
     • Older the property the lesser the value, in this example we have used -3% per year.
     • Construction quality adjustment is only done if the comparable property is not excellent (the condition of the property to be valued). Here property 3 is of average quality so we assume a 5% adjustment for that.
       
   Once the adjustment percentages are computed, we aggregate all the adjustments by summing each component to arrive at a net adjustment figure (e.g. for property 1 the net adjustment is 5%(=0%-1%+6%+0%). This adjustment factor is applied to the raw price per sq. footage to derive the adjusted price per sq. footage (e.g. for property 2 it is Rs. 32,308= (30,769X1.05). We use the same methodology to derive the adjusted price per sq. ft for comparable properties (see the red highlighted box for below). Finally the price per sq. ft for the subject property is derived by taking the average of the comparable properties. For the property under consideration it is Rs. 32,419(=(32,308+33,450+31,500)/3).
   
   Once we have the price per sq. ft for the subject property then we simply multiply with the gross area to come up with the final valuation. In this case it is 32,419X12,000=Rs. 39 Crores.
   
   
   We conclude the first part of the series by pointing out some of the strengths and weaknesses of this approach. 
   
   Advantages: The key strength is the simplicity and the transparency of the methodology. As it is grounded in the recent transactions it reflects the impact of past market movements properly.
   
   Disadvantages: On the negative side, the valuation depends on a plethora of subjective judgments in form of the assumed adjustment factors. Thus a detailed understanding of comparable properties is essential for the valuation. The other shortcoming of this methodology is that it is independent of the future outlook. For example if the market is overheated in the last couple of years and is expected to crash in the future then this valuation methodology will not be able to insulate the investor form the impending crash.
   
   

   Next week, we will delve into the other valuation method which is designed to address the above two shortcoming and provide a different way of valuing a property.