All property has financial value, but how exactly do you work out what that value is? That’s where a valuation report comes in.
House valuation is an important part of any transaction. It makes sure that the buyer understands the value of what they’re paying for, and the owner understands the value of the asset they’re looking to sell.
But how does that all work?
A Simple Explanation Of A House Valuation
Valuation is the process of assessing and analysing a property to ascertain what it’s worth on the open market.
There are a number of circumstances where property valuation might be requested, but is most frequently used as part of receiving a home loan to finance a property purchase.
Two of the main approaches used for property valuation are the costing and comparison approach. They assess the estimated market value of a property at the point of sale using slightly different methods.
But how do you check property value when it comes to a potential investment for rental return purposes? That’s where the investment method of valuation comes in to help!
The Investment Method Of Valuation Explained
The investment method of valuation is a property valuation method designed to assess the potential return on investment through ongoing income from a property.
It’s particularly well suited to buy-to-rent or certain types of commercial property.
The focus of the investment method approach is to assess and estimate the value of property compared against the potential income it could generate.
For that reason, it’s also sometimes referred to as the income capitalisation approach.
How Does The Investment Approach To Valuation Work?
The investment approach works by assessing the market rental rate of a property against the capitalisation rate, or cap rate.
The cap rate in simple terms refers to the potential profitability of a property.
The first element of this approach is understanding the Net Operating Income (NOI). That’s a calculation to assess the total income expected over a period of time.
This all starts with the market rental rate, assessed by comparing the property against similar properties rented under competitive and open market conditions.
That means if you’re assessing a 3-bedroom condo, it’s only compared against market rental rates for other SIMILAR properties in the nearby area, and not a luxury bungalow 20 miles away!
Of course you can’t guarantee full occupancy over the entire period of the tenancy, so market understanding of potential vacancy rates should be used to provide a guideline gross income.
Rental properties also incur costs outside of potential vacancy.
That’s things like maintenance, rental fees, ground management, and other possible costs. Subtracting this estimate from the gross income gives you your NOI.
Next up is the current market value. That will almost certainly involve using a comparable cost (like a comparison evaluation) to assess the market value of the property at the point of sale.
It’s an average of all comparable sales used to assess the potential sale price of the property.
Finally it’s time for the cap rate. That’s a simple function of dividing the NOI by market value, then times by 100 to get the percentage.
So if your property has a value of RM400,000, and the NOI comes out at RM40,000, your cap rate is 10%.
If your figures ever come out that clean in real life, there’s a good chance your valuation professional reallyyyy doesn’t like long division.
The Pros And Cons Of The Investment Method
The investment method is a great way to get a property valuation report that’s well-suited to a potential rental property.
But like all valuation methods, it comes with both its benefits, and its drawbacks.
- Pro: A good way to assess the potential rental value of a given property.
- Pro: Enables comparison between properties to understand optimal investment opportunity.
- Pro: Offers comprehensive financial analysis of an investment in advance.
- Con: Can be a complicated process which relies on certain assumptions.
- Con: No guarantee that estimated costs align with true real-life operating costs.
- Con: Relies on comparison properties for both cap rate and rental analysis.
Is The Investment Method The Right Approach For Me?
If you’re looking to check property value in relation to potential rental returns, the investment method may well be the right choice for you.
If you’re just looking for a house valuation that assesses the market value of a property for sale or purchase, then the comparison or costing method is far more likely to be used.
While the investment method does face challenges around accurate gathering of data for market rental rates, and property market valuation, it’s by far the most suitable method for analysing investment for rental purposes.
But if in doubt, speak to a financial expert or valuation professional to understand what’s right for you.
Looking to evaluate your own investment potential? First off, you’re gonna need to know what are some of the factors that impact property value you probably didn’t know about. From there, you’ll have a clearer picture of what to look out for before you begin your calculations.