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2.4.3 Basics of Property Appraisal

Properties may be valued according to various techniques which can be classified under three main approaches (Comparison, Cost, and Income methodologies), the application of which may involve different criteria.[1]

(a) Comparison methodologies:

• Sales Comparison Approach;

• Hedonic models;[2]



(b) Cost methodology;

(c) Income methodologies:

• Direct Capitalization Approach;

• Financial Approach (DCF analysis models).

The different methodologies are based on different principles and they should also be adopted jointly if required by the complexity of the asset to be assessed. In order to establish which approach is to be used in different situations, it is appropriate to compare them briefly with one another.

Under the Sales Comparison Approach, the value of an asset is obtained on the basis of the prices for concluded transactions which may be defined as comparable. This approach is based on the assumption that no rational buyer will be willing to pay a price that is higher than the cost of buying similar assets with the same utility. This assumption is premised on the two fundamental principles of substitution and equilibrium between supply and demand. According to the substitution principle, the value of an asset is the price that should be paid for a perfectly identical asset, whilst according to the equilibrium principle, the price of an asset is directly dependent upon the market (supply and demand) and is therefore the synthesis of the negotiation process.

The Cost Approach is based on the principle that no rational buyer will be willing to buy a property at a price which is higher than the cost of land in the same area plus the cost of building a property with comparable characteristics, after accounting for the loss in value resulting from the ageing of the building. The valuation is therefore based on the measurement of three different elements: the value of the land, the construction costs for a building with similar characteristics, and the adjustment factors that take account of depreciation due to time and obsolescence. A fundamental element within this approach is also the principle of highest and best use, according to which the value of an asset is dependent upon the most probable use which is physically possible, financially feasible, and legally permitted and which offers the highest return on investment.

Finally, the Income methodologies are based not only on the principles of substitution and equilibrium between supply and demand discussed above, but also on the principle of expected future economic benefit, according to which a rational buyer will not be willing to pay a price higher than the present value of the economic benefits which the real estate asset will be capable of generating over its lifetime. These approaches therefore presuppose the determination of an economic benefit (which may be defined as single income or future cash flows) and a time coefficient which takes account of risks inherent in its future economic benefit (capitalization rate or discount rate). The economic benefit of an income producing property is principally the rental income which it may generate net of operating expenses:[3] it becomes fundamentally important to identify the level of rental income which the asset is able to generate by analysing a sample of comparable properties on the rental market. It is therefore necessary to analyse rental transactions (rather than transfers of ownership, as occurs under the Comparison methodologies) in order to determine future income flows.

Consequently, the Income methodologies work well when assessing a real estate asset with the following characteristics:

1. ownership rights are transferred relatively infrequently (e.g. commercial properties in general such as shopping centres, large office buildings, and logistic parks);

2. there is a significant rental market (with a clear distinction between users and owners[4]) on the basis of which comparable market rents can be determined;

3. the value of the property is not directly dependent upon a physical measure (e.g. price per square metre), but rather upon its capacity to generate income in a manner not strictly related only to its surface area (e.g. shopping centres, hotels, or cinemas). Comparison methodologies

In order to apply the Comparison methodologies it is necessary to have a sufficiently broad historical set of transactions relating to similar assets. By definition, there are never strictly speaking absolutely identical properties since each is unique at the least in terms of its location. However, in practical terms, it is possible to identify the main characteristics which contribute to determining the attractiveness of a property and subsequently its value. The price of a property is always a function of the matching of supply and demand, and will tend to change in line with market trends.

There are also other approaches which fall under this category, including for example the Multiplier Approach. When applied to economic dimensions, multipliers make it possible to determine the value of an asset: nonetheless, the lack of a precise scientific foundation has not limited its development, thanks to the ease and immediacy with which it can be used. Multipliers are generally adopted when determining the value of a given business, rather than a specific real estate asset. As such, the valuation will generally refer to the business's core operations and the characteristics of the property used for it. Cinemas, hotels, golf courses, and fitness centres are just some of the types of assets for which appraisers in practice commonly adopt rules of thumb or market based multipliers. The object of the valuation will therefore be both the property and the business carried on within it (cinema, sports centre, hotel etc.).

The Sales Comparison Approach uses data for comparable properties which have been recently sold in order to determine the value of the property. It is possible to estimate the value of a property on the basis of sale prices for comparable properties by applying adjustments which take account of the specific features of each property. The use of this approach involves three steps:

1. selection of comparable properties;

2. normalization of the sale prices for comparable properties;

3. adjustments.

First and foremost it is important to select properties which are comparable to that which is to be valued. It is therefore necessary to analyse, value, and verify the existence of equivalent properties, and to analyse the prices at which they have been sold, taking account of the elements which impinge upon supply and demand. Properties are compared taking account of their physical characteristics (age, quality, state of maintenance etc.) and location. It is necessary that the characteristics of the properties considered to be comparable are as similar as possible to those of the property to be assessed and that the comparable properties have been sold recently (generally during the last three to six months) at normal market conditions:[5] in order to do so at least three or four properties have to be chosen. Prices agreed to in situations resulting from testamentary succession or, normally but not always, from auctions should not be considered since they do not meet the prerequisites of normality.

The second step involves the normalization of the sale price for comparable properties by expressing it in terms of a unit for comparison. For most properties, the unit considered will be the surface area, and hence the calculation will be made with reference to prices per square metre.[6] The unit of measurement considered may differ for certain types of properties, depending upon which unit is generating revenues. The unit of measurement is specific for each different type of property,[7] and can be extracted from the sample of comparable properties analysed. The final value of the property will be obtained by multiplying the average price for the unit of measurement extracted from comparable transactions by the units of the property to be assessed.

The third and last step involves making adjustments, since no two properties will ever be perfectly identical, for example due to differences in age, state of maintenance, orientation, noise levels, and accessibility. After collecting all information relating to the property and the market, it will be necessary to verify the differences between the information obtained and the individual property to be assessed. For this reason the criterion will never apply to properties which, by their nature, are effectively unique from all points of view. Even for properties which may appear ex ante to be entirely homogeneous, such as each half of a semi-detached house, there may be differences in terms of orientation or noise (for example, one half of the house may be closer to a road). This step is important because it could call into question the choice of comparable properties.

Practitioners often consider that two properties are not comparable if it is necessary to make an adjustment in excess of 20% of the price per unit. If this is the case, it will be necessary to select other properties which are genuinely comparable to the property to be valued or using a different methodology. Cost methodology

The Cost methodology is based on the principle that in most cases an investor will not be willing to pay a price for a property which is higher than the land on which it is built plus the cost of rebuilding it after accounting for any depreciation. The Cost Approach is therefore based on a principle of replacement. In effect, the potential buyer will choose between purchasing an existing property and building a property with the same characteristics on a similar plot of land, taking account of the level of depreciation of the existing property. The sale price may differ from the equilibrium value of the replacement cost if for example some of the characteristics of the property do not match up with what the buyer is looking for or if the buyer wishes to take possession of it immediately. Under the former scenario the value will be lower, whereas in the latter it will be higher.

Calculating the value of a property is equivalent to looking for the correct value of the property originally built to which the value of the land is added. Under this approach, the first cost calculated is that of rebuilding the property as new. Although this can be done in various ways, the most frequently adopted solution is to value the surface area according to a construction cost per square metre or cubic metre. Estimating the value of a building by multiplying the number of square metres by the average construction cost per square metre is a relatively simple operation. However, the various constituent parts of a property do not have the same cost per square metre: in order to avoid excessive distortions, it is possible to break up the total number of square metres into the main elements (garage, residential units, commercial units etc.) and multiply the surface area of each component by the relevant construction cost.[8]

Once the cost of reconstruction as new has been estimated, in order to determine the value of a property it is appropriate to quantify the property's loss in value compared to the cost of rebuilding as new. This value loss may occur for three main reasons:

1. wear and tear;

2. functional obsolescence;

3. economic obsolescence.

The level of wear and tear of the property depends upon its age, building quality, level of ordinary and extraordinary maintenance, as well as its use. This last factor is for example dependent upon the title according to which the property is used: all other things being equal, an owner-occupied property is indeed usually in better condition than a rented property. The location of a property may also have an impact upon the extent of the level of wear and tear of a property, for example due to factors such as exposure to the elements and pollution.

A loss in value may also be caused by functional obsolescence, that is the failure of the property to meet up with the functional requirements of contemporary buildings, taking account of construction standards and market requirements. There are several examples of this, such as in residential units the number of bathrooms, the presence of a lift, the type of heating, the quality of insulation and soundproofing for the building and in offices the connection to new computer technologies, energy efficiency, and green building standards.[9] All of these elements have changed significantly over time, and are also reflected under current legislation. For example, a flat without a lift or with an antiquated heating system will be functionally obsolescent.

Economic obsolescence is perhaps the hardest element to quantify. Here it is necessary to assess whether there is real demand for this type of property or whether there is no demand for some of its characteristics, including even its current intended use. This class should only include factors which can impinge upon the building's value, since any negative impact on the value of the land will already appear in the calculation of its value. A detached house with luxury fittings for which there is no demand illustrates the fact that a property's value does not vary in proportion with its cost. Even though some very luxurious fittings, such as gold-plated taps, have a very high installation cost, they will only be of value if there is demand for this type of characteristic. Hotels located in a region which no longer attracts clients enable one to sketch out the impact of economic obsolescence, which may have an effect on the value of the building without necessarily affecting the value of the land. If it is possible to transform the building in which the hotel is located to other uses, for example residential units, it may be the case that the value of the land does not suffer. On the other hand, the value of the building will fall by the amount necessary in order to adapt it to the new use, in addition to other depreciating factors. In any case, the boundary where the impact on value is to be measured is rather difficult to determine.

The measurement of the degree of depreciation of a property, and hence the corresponding amount, is often relatively difficult, especially if the building is particularly old. The simplest way of measuring depreciation starts from an annual depreciation rate, for example 2% per annum if the lifetime of the building is estimated to be 50 years. It is also possible to consider a non-linear depreciation of the property by choosing lower rates for the initial years during which the property is used and subsequently moving to higher rates. Whilst these solutions are simple, they are often unsatisfactory. In fact, it may be more appropriate to consider the useful life (and hence the rate of depreciation) of each constituent part of a building.

Alternatively, rather than attempting to determine the useful life of an old property or of each constituent part in order to calculate a depreciation coefficient, an estimate may be made of the cost of refurbishment necessary in order to ensure that the property has a useful life that is comparable to a new property. The renovation cost will then be deducted from the cost of reconstruction as new in order to obtain the value of the renovated property.

The estimated value of the property is obtained by adding the value of the land to the corrected construction cost. The value of the land may be determined using information relating to the recent sale of plots located within a comparable area, according to the comparison approach.

When valuing greenfields as well as brownfields (i.e. abandoned buildings), the residual value criterion is often used, which involves identifying the highest and best use of an area, taking account of applicable local planning regulations. From an economic point of view,

the best possible use of land is often a property which generates the highest possible rental income or sale prices. This means that first of all one must choose the type of building and the floor area ratio which make it possible to achieve this objective. Secondly, an estimate will be made of the price for which the property may be sold on the market, from which the construction cost for that type of building will be subtracted. The calculation will also have to take account of the profit which the developer wishes to make on the operation, depending upon the time and risk involved as well as the financial costs, thereby obtaining the maximum amount which he will be willing to pay for the land. The application of this methodology may entail the simple summation of costs and revenues, or it may require the discounting of projected cash flows in a manner similar to the approach described in the following paragraph. Income methodologies

Income methodologies seek to determine the value of a property by estimating its capacity to generate economic benefits during its life. The reference to income and cash flows results from the fact that similar methodologies can be and in fact are, applied to all other asset classes.[10] These approaches are premised on the fundamental assumption that a rational buyer will not be willing to pay a price which is higher than the present value of the benefits which the asset will be able to produce in its lifetime. This principle, which operates alongside the principles of equilibrium and replacement on which the Comparison Approach and Cost Approach are based, implicitly assumes that this price may not be higher than the cost of buying similar properties with the same level of utility.

The Income methodologies make it possible to express the value of a property as a function of the same factors which determine the value of any asset: projected income and the risk associated with securing this income. In fact, according to these approaches, the value of an asset is dependent upon the future economic benefits which it will be able to produce over the course of its lifetime.

The practice and theory of real estate appraisal are dedicating increasing attention to the Income methodologies, which are well adapted to valuations for properties which generate a regular income flow (consider income producing properties such as offices, shopping centres, hotels etc.). The price of the space (rent) is dependent upon supply and demand, and it is possible to ascertain it from the market analysis of rent levels recently agreed under new leases annual rent per square metre or square foot).

The value also depends upon the possibility of selling the property in cases where it is destined exclusively for a specific function and in which there is a low level of fungibility. Here, the surface area is not the main driver of value, and hence a different criterion has to be used in order to estimate the value of that space. In cases involving a fungible property (i.e. office, logistic), it can simply be asserted that the future cash benefits will result from the sale or rental payments; on the other hand, for properties with a specific a business operating within them (such as hotels or shopping centres) it will be important to determine the maximum sustainable rent.

The Income methodologies involve the application of two different criteria which are based on different ways of measuring projected income, with different assumptions regarding the relationship between income and value:

• the Direct Capitalization Approach is used in order to convert the forecast for expected income over one single year into an indication of value, whereby the estimated income is divided by an appropriate capitalization rate (one income and one rate);

• the Financial Approach (based on DCF analysis models) is used in order to convert all future economic benefits into a present value, discounting all expected benefits (cash flows) at an appropriate discounting rate (expected total return).

Whilst the two criteria follow the same principles, there are significant methodological differences between them and the results may also be different. In particular, the differences between the Direct Capitalization Approach and the Financial Approach relate to the following points:

• the definition of economic benefit which the asset is able to produce:

• the Direct Capitalization Approach is based on an accounting measure of income (revenues);

• the Financial Approach identifies a cash flow (which may only occasionally coincide with the equivalent revenues);

• the time horizon considered:

• the Direct Capitalization Approach determines the value of an asset through an annual income and a capitalization rate related to this single reference period;

• the Financial Approach works with a multi-period process through the analysis on a time horizon extended to more than one period;

• the calculation algorithm:

• the Direct Capitalization Approach is based on the capitalization of a future benefit, transforming a current indicator of income into an indicator of value;

• the Financial Approach uses the discounting principle in order to anticipate future cash flows.

The Income methodologies are based on two different rates:

1. the capitalization rate, which compares the value of an asset with one single-period income (Direct Capitalization Approach);

2. the discount rate, which is used to discount the cash flows generated by an asset and which represents the total return required by the market for an investment with the same level of risk (Financial Approach).

Both rates are expected measures of returns:

1. the capitalization rate is the expected yield, that is a measure of income return only (yield equal to income divided by price or OMV);

2. the discount rate is the expected internal rate of return, that is a measure of total return (including both income and capital gain returns). Choosing the correct approach to valuation

Real estate valuation is a fundamental problem when disbursing loans and, in order to be reliable, it is necessary that the approach used corresponds to the purpose of the valuation and the type of asset considered.

The Comparison methodologies usually predominate in the valuation of residential properties since it is easier to obtain comparable data from the ownership market than from the rental market. Moreover, even though they may differ from one another, at times significantly, residential properties are nonetheless more homogeneous in nature, and in many countries, being a prevalence of owner-occupied properties, their value is less affected by lease agreement conditions.

Conversely, for commercial properties the Income methodologies prevail, precisely due to the relative infrequency of transactions and the highly heterogeneous nature of properties; cash flows and yields are more homogenous than physical characteristics. Consider the case of shopping centres: the number of transactions within a given geographical market may even be nil over a certain period of time, which means that it will be necessary to refer to properties sold in other similar markets in order to obtain an indication of the relative yield. Moreover, the value of a shopping centre, as well as that of all properties in which the activity carried on inside has a direct impact on their economic value, is only indirectly dependent upon the surface area of the property. In this specific case, the shops' capacity to generate revenues is the key element in determining the rent, and is dependent upon factors such as the merchandising mix, the presence of anchor tenants, the overall quality of the project, and its location.

In addition, the Financial Approach appears to be the most complete for commercial properties, since it requires a consideration of all parameters necessary in order to determine the projected cash flows. This criterion has developed significantly over recent years, above all within sophisticated approaches which make it possible to measure the value's sensitivity to changes in different parameters. It therefore amounts to a risk management instrument, which is particularly precious and meets with the increasingly stringent legal requirements of some institutional investors. This approach is particularly suited also to the valuation of income generating residential properties as blocks of apartments and residences. The Income methodologies are increasingly establishing themselves in more mature markets in which the separation between owners (predominantly institutional investors) and users (both companies and families) is increasing: this therefore leads to the creation of a very significant rental market which makes it possible to detennine the income generating capacity of properties in more detail.

Finally, the Cost Approach is the only possible way of valuing atypical assets, especially those for which there is no rental market and no sale market. In this case the Cost Approach will be useful, although it must be remembered that the value of this type of property will inevitably be dependent upon supply and demand dynamics which are reduced (or indeed entirely absent in cases involving some infrastructure non-producing cash flow). Finally, this approach makes it possible to determine the value of an area on a residual basis.

The appraiser should base his assessment on the different approaches when estimating the value of a property. Accordingly, for residential properties, it may be possible for example to pair up a comparison approach with an estimate made on the basis of the Direct Capitalization Approach. For commercial properties, on the other hand, the comparison approach may be used in conjunction with the Financial Approach. It is appropriate to insist on the need to analyse the differences in value resulting from the adoption of the different approaches. An analysis of these differences should prevail over a simple calculation of the average of the values obtained. In fact, it will make it possible to try to understand the reasons for the differences thus ensuring that the values allocated to the various different parameters for the valuation are plausible.

  • [1] For further references on property valuation please see Cummings and Epley (2013), Hoesli and Morri (2010), Scarrett (2010), Baum and Crosby (2008), Geltner et al. (2007), Schram (2006), Kahr and Thomsett (2005) and Hoesli and Macgregor (2000).
  • [2] The hedonic (regression) models have been developed in many countries in order to value residential real estate: they are based on the notion that the supply of and demand for heterogeneous assets are comprised of supply of and demand for each characteristic of those assets (Lancaster 1966 and Rosen 1974). Generally speaking, it is relatively easy to observe real estate supply and demand on the market: the supply of a certain type of asset consists in the assets put up for sale, whilst the demand is represented by the investors who intend to purchase that type of asset. Since these are observable elements, real estate supply and demand as a whole may be classified as explicit supply and demand. On the other hand, supply and demand in relation to each characteristic feature cannot be observed directly, and such cases are accordingly conceptualized as implicit supply and demand.
  • [3] This principle remains valid also for owner-occupied properties, since the economic benefit consists in the alternative cost of the property on the market, or the opportunity cost forgone by exploiting the property for personal use.
  • [4] In many countries this is not the case for residential properties where there is a high percentage of owner-occupied properties.
  • [5] Under conditions which meet the requirements defined above in order to determine the OMV.
  • [6] Or per square foot, according to the unit of measurement adopted in a specific country.
  • [7] Each different type of property has its own unit of measurement: price per square metre for residential and office, price per door or per window for high street retail, price per parking space or berth, price per seat in cinemas, or price per room in hotels etc.
  • [8] The cost calculation is often estimated in a very detailed manner, including cost for single parts of the building.
  • [9] On green buildings market values please see Morri and Soffietti (2013).
  • [10] The other criteria introduced in the previous paragraphs are specific to real estate assets, whilst the income approaches are entirely equivalent to the techniques used in corporate valuation and for any other asset class (e.g. shares and bonds).
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