Hartatanah-logo

Understanding Property Valuation

 

ID-10030595

 

1) What are the definitions of property value?

There are several definitions of property value according to the purpose of valuation. The most common types of value are:

Market value – is the estimated amount for which an asset should exchange on the valuation date between a willing buyer and a willing seller in an arm's length transaction, after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion.

Value-in-use – is the net value of a cash flow that a property generates for an owner under a specific use. Value-in-use is the value to one particular user, and may be above or below the market value of a property.

Investment value - is the value to one particular investor, and may or may not be higher than the market value of a property. Differences between the investment value and its market value provide the motivation for buyers or sellers to enter the marketplace. It is the value of a property to the owner or prospective owner for individual investment objectives.

Insurable value - is the value of property covered by an insurance policy. Generally it does not include the site value.

Liquidation value - is a forced-sale value typically used in bankruptcy proceedings. It's a value that assumes a seller is compelled to sell after an exposure period normally required in market-sale scenario.

 


2) What are the differences between Value, Price and Cost?

Value

  • Value is not a fact.
  • Value is an estimated worth of a property according to the valuation definition used.
  • Market value reflects the market's view of the benefits accrued from owning a particular property.
  • Value is determined by scarcity of the property, its usefulness or utility, its power to serve people's needs and desires, and the purchasing power of potential buyers in a market.
  • Value is not intrinsic or inherent in the property, but is relative between the valuator and the property being valued.

Price

  • Price is money obtainable from a person willing and able to purchase a property.
  • Price is the amount asked, offered and paid between the seller and the buyer. When done, the price is a historical fact.
  • Due to financial capability, motivations or special interests of buyer and seller, price paid may or may not relate to value, but is a general indication of its relative value.
  • Price is fixed by supply and demand of a particular property in a market.
  • Price becomes unrelated to value when forces of demand and supply operate on a particular property in a market.
  • One person's price is another person's cost.

Cost

  • Cost is the price paid or amount required to create or produce a property, and when built, cost is a historical fact.
  • Price paid by a buyer becomes cost to the buyer.
  • Cost depends on the factors of production - such as land price, labour cost, capital cost and the amount of risk involved in the production of property.

 


3) Who is a valuer and what does a valuer do?

A Property Valuer is a professional who has been educated and trained to determine the value of fixed property, to carry out feasibility studies and provide expert advice on property related matters.

The Valuer needs a thorough knowledge and understanding of the interacting influences that create, sustain or diminish the value of property. The Valuer does not invent value, but interprets market forces, which determine the value.

Valuers are qualified to undertake valuations in all classes of properties, including commercial and industrial properties; all types of residential properties, agricultural and special use properties.

However, most Valuers tend to specialize and do not undertake the full range of valuations. It is therefore vitally important for clients to select and appoint a registered Valuer with the relevant practical experience required to undertake the specific valuation.

Valuers' practice is regulated by the Valuers, Appraisers and Estate Agents Act 1981.

 


4) What are the methods of property valuation?

There are basically five methods of valuation, which are:

  1. Direct Comparison Method
  2. Cost Method
  3. Investment Method
  4. Profits Method
  5. Residual Method

Direct Comparison Method and Cost Method are more commonly used by laymen as they are more easily understood. These methods are explained here in more detail.

The Investment Method, Profits Method and Residual Method are more complex and academic. Only outlines of these methods are provided here for the purpose of this FAQs, intended for laymen.

 

Direct Comparison Method

  • By directly comparing a subject property with similar properties from past transactions.
  • It is a subjective opinion that tries to be as objective as possible.
  • Properties are compared on per square foot/square meter basis.
  • Every property is unique (heterogeneous) - no two properties can ever be identical, and locations always differ.
  • There are also differences in position, plot size, floor area, number and arrangement of rooms, architectural design, age and condition.
  • When comparing properties, adjustments have to be made in value to reflect the differences in location, age and condition, tenure (freehold or leasehold), time of transaction (whether market has been stable, rising or falling?)

The problems with this method:

  • Difficulty in finding the data and information of suitable comparable properties.
  • Full details such as the negotiating strengths between the seller an buyer (whether it was a forced-sale or due to relationship) are not known.
  • Likewise, legal encumbrances and internal conditions of properties compared are not apparent.
  • A comparable property may be transacted long ago and market price has since changed.
  • Sometimes there are no comparables at all.
  • How to adjust the value objectively since some differences are subjective.
  • Value, after all, is what finally someone is willing to pay for.

However, Direct Comparison Method is commonly used as the principle behind it is sound - that a prudent person will not pay more than it costs to buy a comparable substitute. This is the simplest, most easily understood and most reliable method, though not perfect.

 

Cost Method

  • Also known as Contractor's Method or Depreciated Replacement Cost Method.
  • It is used for properties that are individually designed, do not normally come onto the market, not used for profit making, and without comparables, such as an architecturally unique bungalow.
  • It values a property by estimating the cost of replacing the site (land) and building, then make allowance for depreciation of the building.
  • As cost may not be an indicator of market value, cost method should only be used where other methods are inappropriate.
  • The basic principle behind this method is substitution - that an informed, rational investor will pay no more for a property than the cost to produce a substitute of equal quality.
  • Cost here refers to the total cost to an investor, not to a contractor.
  • Cost method is often used in assessing reinstatement cost for fire insurance, and asset valuation in accounting.

Outline of Cost Method:

Value of an existing property = Cost of site + Cost of Building - Depreciation

Problems of this method:

  • It works on the assumption that cost and value are the same, which they are not.
  • How much to allow for depreciation or obsolescence of the building is a matter of subjective opinion.

 

Investment Method

  • Also known as Income Capitalization Method.
  • This method is often used in valuation of income-producing properties for investment purpose.
  • The principle is to estimate the present worth of rental income stream from the property in the future, and capitalizes the income into a value indication.
  • This is done by using a revenue multiplier (capitalization rate) applied to a net operating income.
  • The capitalization rate is derived from comparisons with other similar property investments.
  • Capitalization Rate = Net Income / Capital Value

                      
Outline of Investment Method:

Net Income x Capitalization Rate = Capital Value

Advantages of this method:

  • This method enables a quick estimation of capital value.
  • Can be used to check the feasibility of a property investment against other investments.

Disadvantages of this method:

  • It is assumed that rental income will not change.
  • Lack of market data to find an accurate capitalization rate.
  • Minor variation in capitalization rate results in substantial change in capital value.

 

Profits Method

  • This method is used where there are no comparable properties exist, such as hotel, petrol station, golf course and leisure properties.
  • It is based on the economic theory that rental value of a property is a function of its earning capacity.
  • The level of profit from the business operating in the property determines the price an investor will pay for the opportunity to obtain the profits.

Outline of Profits Method:

            Turnover of Business
Less:     Purchases
            -----------------------------
            Gross Trading Profit
Less:     Working Expenses
            ----------------------------
            Net Trading Profit
Less:    Tenant's Interest on Capital
            ------------------------------------
            Divisible Balance

Divisible Balance is split into Tenant's Profit and Amount Available for Rent (Rental Value).
The rental value is then capitalized to indicate the capital value of the property:

Rental Value x Capitalization Rate = Capital Value

Problems of this method:

  • Can only be used where the business is profitable.
  • Needs turnover figures of 3-5 years, the accounts of which are not always available.
  • How to decide the the percentage of split from net profit to establish the rental value.
  • Profits may be due to other factors such as the tenant's diligence or lack of competition.
  • Whether the profits can be sustained in future is unknown.
  • What capitalization rate to use, as it is sensitive to slight variation in capitalization rate.
  • Profitability often depends on management.

 


Residual Method

This method is often used by property developers to arrive at a feasible value for a development or redevelopment land they are contemplating to acquire.

Outline of Residual Method:

                Gross Development Value (GDV)*
Less:        Gross Development Cost (GDC)** + Developer's Profit
               ---------------------------------------------------------------------
                Residual Land Value upon completion
Multiply:    Present Value Factor over development period (discounting)***
                ---------------------------------------------------------------------
Equal:       Current Residual Land Value

 

*Gross Development Value is the total retail or sale value of all the units in a development.

** Gross Development Cost is the total of all costs incurred from initiation to completion of the development project, which include demolition of old building (if any), site preparation, construction costs, fees and expenses, financing costs and holding cost during development period.

***Residual Land Value upon completion is discounted due to the concept of time value of money. All future cash flows are estimated and discounted to give their present values, in an analysis known as the Discounted Cash Flow (DCF). As property developments take years from land acquisition, planning to marketing and finally seeing profits, this future value of profit has to be discounted to reflect its present value.

 

5) What is meant by Highest and Best Use (HBU) in valuation?


Highest and Best Use (HBU) is a concept of valuation that seeks the highest potential value in land, often used to study the feasibility of development or redevelopment projects to decide on the best type of development - ie. residential, comercial or industrial; high, medium or low rise or density.

The principle behind this concept is that value of a property is directly related to the use - the reasonably probable use that produces the highest property value.

The test of HBU:

  • Legally allowable - the intended improved use of a property should be allowed by zoning status, government regulations, and the restrictions or covenants in deeds.
  • Physically possible - the potential use must suit the size, shape, topography, geological properties and other characteristics of the site.
  • Financially feasible - the proposed use must generate adequate revenue to justify the costs of construction plus profits for the developer.
  • Maximally productive - the intended use must produce the highest net return (profit) on investment compared to alternative uses. 

 

6) Why do valuations of a property by different valuers differ, sometimes widely?

Valuation is both science and art. When comparing locations, conditions, improvements, potential and other factors, valuers often have to evaluate them subjectively while trying to be as objective as possible. Valuation is an educated estimate of property value - sometimes said to be a "guesstimate".

The different purposes of valuation - such as to determine market value, value-in-use, investment value etc. (see item 1) also result in differing value of a property.

 

7) Why does a bank need to value a property (by the bank's panel of valuers) before approving a loan application?

A bank needs to value a property to ensure that it is really worth the price the buyer is paying for, so as not to lend out more money than the property is worth. Banks usually require that valuations be done by their own panel of valuers, whose valuations the banks feel comfortable to rely on.

 

8) Why are banks' valuations of properties often lower, sometimes much lower, than the transacted prices?

Market valuation is different from mortgage valuation. Banks valuations are conservative and are often lower than transacted prices due to:

  • Banks' instructions to their valuers to value low in view of money supplies, market conditions and lending policy.
  • Valuers can be held responsible for "over-valuation" that results in banks unable to recover funds in foreclosures. To be safe, valuers rather err on the side of caution and value conservatively.
  • Banks' valuations often have to be produced quickly, and due to time constraint, valuers may cut corners and produce inaccurate reports, or value low to be on the safe side.

 

9) What happens if a bank's valuation of a property is lower than the transacted price?

A purchaser will have to come out with more cash outlay if this happens. For example, a property is bought for RM500,000:

If the bank values it at full RM500,000, loan amount at 80% margin will be RM400,000, and borrower's cash outlay will be RM100,000.

If the bank values it at only RM450,000, loan amount at 80% margin will be RM360,000, and borrower's cash outlay will be RM140,000 - ie. RM40,000 more.

If a buyer is unprepared for more cash outlay, s/he may end up not able to pay for the purchase and risk having the earnest deposit forfeited.

 

10) I bought a property, what should I do if a bank values it lower than my purchase price?

You may ask the bank to consider upping their valuation and let them know you have to apply for loan elsewhere. Well, in this case, you really need to just to be safe. In a competitive loan market, and especially if you are a borrower eligible for more loan than you need, banks will often compromise and readjust the property value higher to get your business.

 

11) I had spent RM150,000 on renovation, can I add this sum to the value of my house?

It is necessary to point out to the valuer all the detailed improvements done to the house, so that these are taken into consideration in the valuation process. However, in most cases, renovations or improvements done are no longer worth the full original cost incurred due to depreciation, obsolescence and differences in individual preferences and tastes. The valuer makes adjustments to the value of the improvements based on these factors.

 

by Aaron Lee, Property Street

All Rights Reserved

For more details please email This email address is being protected from spambots. You need JavaScript enabled to view it.