Tuesday, May 14, 2013
Broadly, there are three main methods for real estate valuation: Cost Approach Market Comparison Approach Income Approach At a glance, cost approach seems like a very simple method. Cost is simply proportional to how much you buy. Actually in the real estate market, each valuation method has its special area of use. The market comparison approach is most suited for residential buildings, villas, apartments, shops, office units, and other properties with active transactions. On the other hand, the cost approach is often used for properties like public facilities, and properties for special purposes with a small market. The former approach has been discussed in my previous article; whereas in this article I will attempt to explain the latter with the use of examples and by first offering a simple introduction before diving into the subject. Still we have to look at the various definitions of the cost approach, then briefly discuss its concept. Look at Chai Qiang's well-known book, (translated as) "Real Estate Valuation"; in it the cost approach is also known as the contractor's method and depreciated replacement cost method. At any rate, this approach works by first making a valuation and then subtracting the depreciation cost in order to find an objective and reasonable valuation figure. In Cao Jian's famous book, (translated as) "The Theory and Method of Modern Real Estate Valuation", the cost approach is defined as the cost of re-building the property or similar properties and subtracting from it the depreciation cost of new properties. Finally add the value of the land to find the valuation. This definition is identical to that in Investopedia. (Investopedia's definition of "Cost Approach":A real estate valuation method that surmises that the price someone should pay for a piece of property should not exceed what someone would have to pay to build an equivalent building. In cost approach pricing,the market price for the property is equivalent to the cost of land plus cost of construction, less depreciation.) Through definitions these concepts sound abstract and vague, so let us see an example. Firstly I have to state that the cost approach is most often used in apprising new lands used for building, unprofitable properties with minimal market transactions properties in non-mature markets. In short, this approach is used for properties that cannot be valuated by other methods, like public facilities such as schools, hospitals, factories, oil fields, airports, shopping malls, and etc. Now, let us discuss about malls. The cost approach will let us look at things from both the seller's and buyer's point of view. From the former's standpoint, naturally he hopes to obtain the replacement value of the building along with a margin added to it. Thus at the very least, he will hope to recoup the cost of building the mall, land value, fee for ownership transfer, property tax, compensation for re-location, water and electricity charges, communication fuel supply building costs, constructions costs and relocation cost incurred when the building was under construction (for example, if the mall needs 2 years to be constructed, the tenants will have to incur cost for the renting of alternate premises, moving cost and other business losses) interest cost for building loans, insurance fees and natural appreciation in value. Subtracting from all these are the depreciation costs. Finally the rental to be earned (assuming that the mall is leased out) will be added. This final value is the basis that the seller will use in the price negotiation. It is a different story on the buyer's side. He will expect the valuation not to exceed the price on the open market of a similar mall in the same area; otherwise he will be better off buying a plot of land and building a mall on it. Of course, total cost is not simply the additional of cost but the subtraction of it (e.g. rebates). All in all, the cost approach does not make use of a single cost but a number of costs which summation of is complicated. Please note that the "cost" mentioned here is not used in its usual context, rather it is "price". Why? Because true cost (e.g. taxes) generally do not include profit, while price include the cost and a reasonable margin. The owner or developer is paying the "price" for the good and not the "cost" for the good. Of course the "price" also includes the true cost, but the "cost" in this essay is used interchangeably with price. We do not distinguish between the two. The key point of this essay is to simplify the understanding of the cost approach. For the detailed application of this method in valuating a property, we will leave that to a professional valuer. As a consumer, we do not have to concern ourselves with the details because when the valuation report is ready it will specifically state exceptional issues and each item used for the valuation. On hindsight, the cost approach is to strike a reasonable balance between two poles to gain a reasonable and objective valuation. The two poles referred here mean the value that is not under the original cost adding natural price appreciation and the value that is not above the cost of building a similar building in a similar area. Explained this way, it might be easier to understand. All property valuations have to adhere to four rules: Legal compliance Highest and best principle The principle of valuation point Substitution principle Among these four rules, legal compliance simply means the legal acquisition of the land and its legitimate price formation, the details are cumbersome and I will not discuss them here. The highest and best principle simply means to fully utilise every aspect of the property so as to obtain a reasonable valuation. As for the principle of valuation point, it refers to the validity period of the valuation, from the time the valuation is done till the report is ready. At a different point in time, it is possible for the valuation to change. As they say "great changes can occur", although it is somewhat of a stretch to use it here; hence using the phrase "changes can occur with time" instead is appropriate. For example, the property to be valuated had an ideal location (landmark) at the time of valuation but after a few decades when new routes are available or geographical changes have occurred in pace with development, the valuation will no longer be valid. A well-known example would be Ayer Hitam in Johor. Initially a busy transport crossroad and stopover where tourist groups definitely have to pass before returning to Singapore, shops selling souvenirs and local products, along with eateries mushroomed in the area to earn the tourist dollar. But after the highway was built, Ayer Hitam lost its crowd and businesses suffered."It can truly be said: "Where has the bustle of the bygone days gone to? Shops had shuttered and the crowd had dispersed. Valued customers now make use of the highway to return South. Black water (the direct translation of Ayer Hitam) cannot compete with the highway". Real estate prices, which is the initial cost. Including the cost of land acquisition, the entire development (including project design and construction) costs, management and legal fees, interest on bank lending, return on capital, sales fees and taxes, as well as project investment of return. Owners in the sale of properties, the lowest price expectations, the industry is estimated on the basis of the cost method.
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