FINDING INVESTMENT VALUE IN REAL ESTATE

Real estate returns are generated in two ways. First, the income return comes from tenants' rent payments. The income return is a straightforward calculation because all you need to know is how much cash remains after all property expenses have been paid. The second type of return is the capital return, which is the increase or decrease in the value of the property due to changes in market demand and/or inflation. The capital return is more difficult to calculate, and requires the property to be valued or appraised.


If you want to determine the value of a real estate investment, the most accurate method is to sell the property and see how much money you get for it. Of course, the problem with this method is that you would no longer own that asset! In most cases you would want to determine the value without selling the asset, so you would approximate the value of the property based on the price that was actually achieved for other similar properties in the area of interest. 


The approximation process can be inexact and subjective. The real estate market does not have the convenience of a public market, such as that for stocks, where you can continuously value an asset. Also, it is rare for two real estate properties to be exactly the same - unlike two shares of stock in a company, which are exactly the same. A third factor contributing to the subjectivity of real estate valuation is that it doesn't trade very often, so it can be difficult to establish a market value- especially if substantial time has passed since the last comparable trade.


All of the above noted valuation issues have given rise to a group of professional consultants referred to as appraisers. The task of an appraiser is to objectively assess the market value of a property by hypothesizing the most likely price of a trade between an arms-length buyer and seller. Appraisers have appropriate education and experience to perform property valuations, and typically are certified by a professional body which sets appraisal rules that must be followed by all of its members.


Source: Ian Woychuk, Investopedia.com