Collateral Valuation: Credit Risk: Real Estate Valuation Approaches
We discuss the two-step process of real estate valuations in this post. We also briefly review the criteria that appraisers use for selecting the most appropriate valuation approach.
There are two basic steps in the valuation of real estate:
The first step involves estimating a price/ rent/ cost per square meter/ feet (or other acceptable unit of measure) of the property. This may be carried out using either one or more of the following approaches:
- Sales Comparison Approach
- Income Capitalization Approach
- Cost Approach
The second step involves adjusting the estimated price/ rent/ cost for the following factors that differentiate the property being evaluated from similar properties used in the estimation process. These factors include:
- How the property is put to use
- The trends in the real estate price (e.g. actual sales prices, information from neighbors, real estate experts, brokers, sales and mortgage registries, income levels in the area, demand and supply conditions of the market, published land prices and tax rates, regional development plans, availability of mortgage loan facilities, etc)
- The conditions of the property (e.g. structure, age, geographical conditions, location, accessibility to public roads, schools, facilities, utilities, presence of unfavorable facilities, etc.)
- Legal issues (e.g. transfer of property rights, illegal constructions, easements, etc.)
The sales comparison and cost estimation approaches used in the first step are based on the economic principles of substitution which states that when one item can be substituted in the place of another then the values of both items should be comparable. For the sales comparison approach the value of the property is assessed by looking of the values of similar properties that have been recently sold, whereas for the cost approach the value of the property should be comparable to what it would cost of purchase the land and build an equivalent property from scratch.
The income approach on the other hand is based on the principle of anticipation with regard to benefits/ income expected to be received in the future.
The estimation approach chosen by an appraiser depends on:
- The type of property being evaluated
- The use of the appraisal
- The quantity and quality of the data that is available for the analysis
Each method is discussed in greater detail in the following posts. Usually appraisers will apply at least two approaches in estimating a property’s value. The approaches may result in different values that can serve as checks on one another.
In this section we have reviewed the generic procedure followed for estimating the value of real estate collateral. In the posts that follow we will look at specific valuation approaches for real estate.