In broad terms, valuation theory recognises three distinct methodologies (or approaches) in valuation. These are the market approach (sometimes known as the direct market comparison approach), the income approach, and the cost approach.
Market Approach (a.k.a. Direct Market Comparison Approach)
“An approach that provides an indication of value by comparing the subject asset with identical or similar assets for which price information is available”.
The Market Approach measures the value of an asset by comparing recent sales or offerings of similar or substitute property and related market data. The similar transactions method uses valuation data based on historical transactions that have occurred in the subject asset’s direct or related industries. The derived data are then adjusted and applied to the appropriate operating data of the subject asset to arrive at an indication of value. This Approach is very popular in many assignments as it is reflective of the interplay of buyers and sellers in the open market. In order for this approach to be reliable however, it is necessary for there to be a significant number of sales of properties similar to the one for which the assignment is being carried out.
The Income Approach
“An approach that provides an indication of value by converting future cash flows to a single current capital value”.
The Income Capitalization Approach is based on the principle that the value of a property is indicated by the net return to the property, or what is also known as the present worth of future benefits. The Income Capitalization Approach considers a property’s potential cash flow and analyses the present worth of the anticipated future benefits to the owner over an assumed holding period.
The Income Approach is of considerable importance in appraising commercial properties. Most purchasers of this type of property are generally concerned primarily with an income stream, which is what this approach relies on. The disadvantage of this approach is that it is sometimes based on projections of the future.
The Cost Approach
“An approach that provides an indication of value using the economic principle that a buyer will pay no more for an asset than the cost to obtain an asset of equal utility, whether by purchase or construction”.
The Cost Approach is based on the principle of substitution and is valuable in distinctive properties for which there are either very few or no sales of similar properties. Its drawbacks are that it does not sufficiently rely on market preferences, and in cases of older properties, the quantum of depreciation to be charged is not easily identified.
This approach to value follows the following steps:
- Determine the value of the site as if vacant;
- Calculate the replacement cost new of the improvements;
- Estimate the depreciation form from all causes (physical, functional and external);
- Add the site value to the depreciated value of the improvements.
As will be seen from the above, all three approaches vary in effectiveness for specific assignments. Although all three approaches may give reliable indications of value on occasions, frequently, one or two may be totally inappropriate. In arriving at an estimate of value of the subject property, all of the above approaches were considered and one or more of them utilized.
- Market Value: The estimated amount for which an asset or liability 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.
- Market Rent: The estimated amount for which a property would be let on the valuation date between a willing lessor and a willing lessee on appropriate lease terms in an arm’s length transaction, after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion.
- Replacement Cost: The cost of obtaining an alternative asset of equivalent utility excluding retaining walls, boundary walls and fences, swimming pools and other water features, site clearance, professional fees and VAT.
- Contributory Value: The contribution made by a particular feature or component to the value of the whole property.
- Marketable Title: A title not subject to reasonable doubt or suspicion of invalidity in the mind of a reasonable, intelligent person; one which a prudent person guided by competent legal advice would be willing to accept and purchase at a market value.
- Highest and Best Use: The use of an asset that maximises its productivity and that is possible, legally permissible and financially feasible.
- IPMS 3A – Residential: The basis of the size of the building is IPMS3A – Residential which is the area in exclusive occupation measured as follows: to the outer face of external walls for detached dwellings; to the outer face of external walls and to the centre-line of shared walls between occupants for attached dwellings; to the outer face of the external wall, to the centre-line of the party walls and to the finished surface of walls shared with common facilities for multi-unit dwellings – RICS Property Measurement 2nd Edition, January 2018. This standard of measurement is similar to the former Gross External Area (GEA).