Valuation Principles and Property Market Analysis
The concept
Market value is the estimated amount for which an asset should exchange on the valuation date between a willing buyer and a willing seller, both having reasonable knowledge, acting without compulsion. Supply and demand, location, physical characteristics, legal and planning controls, financing costs and the economic cycle drive value. Highest and best use and the principle of substitution underlie every method.
The five methods
- Comparison: adjust comparable evidence for time, location, size, condition and tenure. The staple for residential property.
- Investment (income capitalisation): V = net operating income / capitalisation rate, where the years' purchase is the reciprocal of the rate.
- Cost (contractor's): replacement cost less depreciation, plus land value. Used where there is no market evidence.
- Profits: for hotels, petrol stations and similar going concerns.
- Residual: gross development value less development costs, fees, finance and developer's profit, giving land value.
Traps
- Capitalising gross rather than net rent, forgetting outgoings, void periods and management costs.
- Treating the asking price as evidence of value.
- Mixing capitalisation rate and yield-expressed-as-return incorrectly.
- Forgetting that improvements with no market support are not value.
Worked example
A shop produces a net operating income of RM60,000 a year. Comparable shops sell at a 6% capitalisation rate. Value = RM60,000 / 0.06 = RM1,000,000. Conversely, if a property is asking RM1,200,000 for the same income, the implied yield is 5%, so the buyer is paying for growth, and you should say so in the analysis.
Rule of thumb
State the method and then the rate you chose; the rate is the judgement, and every question that tests valuation is really testing whether you can defend that rate.