What Are the Real Estate Valuation Methods?

In this approach, the property being valued is compared with similar properties that have recently been sold or listed for sale. Adjustments are made for differences such as location, size, age, floor, orientation, view and condition. The logic is simple: if a buyer can pay less on the market for a similar property, they will not pay more than that.

It is the most widely used method for properties where comparable data is plentiful, such as residential properties, plots and standard shops. Its strength is that it reflects how the market actually behaves. Its weakness is that it depends on reliable comparables: asking prices can differ from actual sale prices, and in areas with few transactions it becomes harder to find comparable data. That is why a good report shows the comparables together with the adjustments made.

The income approach is based on the income the property will generate. Rental income or operating income is converted into a present value using certain assumptions. It is used for income-producing properties such as let shops, offices, hotels and shopping centres. From an investor's point of view, the property is an asset that produces cash flow over the years, and its value is related to the present equivalent of that flow.

The accuracy of this approach depends on the assumptions being realistic: rental rates, occupancy and vacancy rates, operating expenses and the chosen discount or capitalisation rate. A small difference in an assumption can change the result noticeably. For this reason, in a report that uses the income approach, it is important to see the basis for the assumptions and the comparable rental data in the area.

In the cost approach, the value of the land is added to the cost of rebuilding the structure, and the loss in value caused by the structure's age and wear is deducted. It may be preferred for special-purpose buildings that have few comparables and do not generate income, such as schools, hospitals or factories. It also provides a supporting check for newly built buildings or buildings under construction.

Its limit is this: cost does not always mean market value. A building that is expensive to build but has no demand where it stands may be worth less than its cost. For this reason, the cost approach is mostly used together with other methods, as a yardstick for comparison.

The expert chooses the method, taking into account the type of property, the state of market data and the purpose of the report. As a general framework, the following can be said: for a residential property, market comparison carries the most weight; for a let office building, the income approach stands out and is supported by market comparison; for a factory, the cost approach and an income analysis may be considered together. For plots and land, market comparison is mostly used; for plots with project development potential, project-based analyses also come into play.

If the values from the methods differ, the expert explains the reason for the difference and justifies which result is given more weight; this is called reconciliation. A good report clearly states why each method was chosen, the source of the data used and the assumptions. If your report contains only a single figure and no reasoning, do not hesitate to ask the expert questions. You may also want to read our article What Is Real Estate Valuation and Why Does It Matter? for the general framework of the valuation process.

In practice, the methods are often used not alone but in a way that supports one another. Consider a hypothetical example: in valuing a let shop, sales data for similar shops in the area is collected first and a value range is found through market comparison. Then a second value is calculated with the income approach, based on the shop's annual rental income and expenses. If the two results are close to each other, the report has a strong basis; if there is a clear difference between them, the expert investigates the reason.

Typical reasons for a difference include the current rent being below or above the market, the comparables being of a different nature, or the capitalisation rate not reflecting market perception. After resolving these reasons, the expert assesses which approach rests on more reliable data and arrives at the final value.

The methods have one more thing in common: they all depend on the quality of the data. Even the most sophisticated calculation will not give a sound result with wrong rental information, an outdated comparable or an unrealistic cost assumption. That is why the date and source of the data used in the report are as important as the method itself. When assessing a valuation, we recommend looking not only at the result but also at the data that leads to it.

Finally, the purpose of the valuation can affect the weight given to each method. In a valuation for insurance purposes, the reinstatement cost comes to the fore, while in a valuation prepared as loan collateral, how easily the property can be turned into cash on the market is more decisive. For this reason, reports prepared for different purposes for the same property can show different values.

The expert first answers these questions: Does the property generate income? Are there similar properties that have been sold recently? Is the building a special-purpose one, or a standard residence or shop? What is the purpose of the valuation? These answers determine which approach will be given the most weight.

For example, the income approach stands out for a let office, market comparison for an apartment in a housing complex, and the cost approach for a factory with almost no comparables. In other words, the method is less a matter of the expert's preference than a result of the nature of the property and the data at hand.

Different approaches may not give the same value. The expert examines the reason for the difference between the results, gives each approach a weight according to the reliability of its data and its suitability to the property, and reports the final value with the reasoning.

Consider a hypothetical example: suppose that for a let shop, market comparison and the income approach diverge noticeably. The reason may be that the current rent is below the market rent. The expert does not ignore this difference; by examining the lease term, the rent increase terms and when the rent could rise to the market level, they decide which approach reflects this property more accurately. In a good report, not just a single figure but also how that figure was reached is clearly written.

In the method section, look at three things: which approach was used, which were not used and why, and the source of the data used. Leaving out an approach is not a flaw; for example, in a special building for which no comparables can be found, market comparison may not be used. What matters is that the reasoning for this choice is written down.

In the comparables table, check that the location, area and sale or listing date of the compared properties are given, and that the reason for any adjustment is explained. In the income approach, the assumptions on rent, vacancy, expenses and yield rate are expected to be listed numerically. Comparing these assumptions with the market facts you know gives you an idea of the report's consistency.

If the report has no details at all about the comparison or calculation, you have the right to ask the firm for information. A transparent firm does not hesitate to explain the basis of the calculation.