Property Valuation Methods and Investment Analysis
- Investment April 12,2011
The most commonly used methods for valuing real assets are:
1. Investment Method:
This is based on discounted cash flow method taking into account the future cash flows that the real property can bring to the investor.
- Typically more prudent and least subjective of all and gives a fairer view of the realizable value of a property.
2. Comparative Method:
- It uses comparative values from latest sales figures in the market and derives capital values for properties and rental yield.
3. Contractors Method:
- A cost-based approach generally used in rating all compulsory purchases.
4. Residual Method:
- Used in development projects where the real estate developer sells most of the property.
In active and established markets of West, any valuation method should give the same values. In turbulent markets of South-East Asia with some investors having excess liquidity and widespread asymmetry of information and no proper supervision of the valuation process, these methods can give different values and results in price mismatch.
We prefer to focus on a method that goes back to the most fundamental concept in finance: "the value of an asset is the present value of future cash flows". For a building project, an investor will receive regular rental income and at the end of the investment period, will receive sales proceeds on disposal of the building.
The first step is to estimate the amount of rental income that the property will earn over the investment period. The rental yield will provide a measure of the income as a proportion of the value of the asset and indication of future returns from the asset. A simple mathematical calculation that helps compare the returns on properties with other invest-worthy asset classes. Calculation of rental yield is as follows:
a)Yearly rental : Rs. 10,00,000
b)Value of building : Rs 1,00,000,00
c)Rental yield = (a/b) x 100 = 10%
Rental incomes normally increase during the years when the property will be rented. The annual increase is linked to a predetermined rate as set in the lease agreement or linked to an inflation index such as the consumer price index. At the end of the investment period, the investor will also be left with a residual value, which is the value at which the investor expects to sell the property.
Next step involves the discounting of the value of the cash receipts as of today i.e. equivalent in todays money. It involves discounting the cash receipts using the required rate of return of the investor. This rate compensates the investor for the level of risk that he or she takes in holding the asset, the opportunity cost of holding the asset i.e. for the time value of money and for the effect of inflation. The after tax yield on a risk free long term and relatively secure Government bond compensates for the last two effects and the required rate of return can be calculated by using such a yield plus an adjustment or premium for risk. An investor should always choose a rental yield that is higher than the long term bond yield.
The investment value of the property will be given by the total of all the discounted cash flows. You can also breakdown this required rate of return and link it to the rental yield. So, for an average property asset, an investor should be looking at a minimum rental yield of, say 7%.
If you analyze commercial properties in India, you will find many cases where rental yields are substantially lower than the long term bond yield and much lower than the 7% figure mentioned above. This implies that either the rentals paid are too low or that the properties are overvalued. Given current economic activity and the level of rental rates on some newly developed properties, it is more likely that in many cases properties are overvalued. This means that current investors are not getting what they should get from their investment.
For Policy Makers and Valuation Offices:
Based on data, rates must be assigned to the different locations and regular adjustments must be made based on the evolution of market price.
- A steering committee must be set up to look after the standards of asset valuations so as to make sure that there are certain guidelines that are respected while the valuations are made.
- It must publish on a regular basis, information about the market prices of properties that have been traded.
- It must consider the setting up of a Property Index for the commercial sector.
Tips for Realty Investors:
- Calculate the required rate of return you need on your property asset.
- If you wish to buy a property as an investment, make sure that you will be able to realize returns.
- The investment valuation method will give a reference for the maximum price you can pay for the property.
- Do not buy a property where rental yields are lower than what a long term bond can give you.
A steering committee must be set up to look after the standards of asset valuations so as to make sure that there are certain guidelines that are respected while the valuations are made.