PROPERTY VALUE FORMULA

There is no single property value formula that applies to any property. The formula for estimating the value of an owner-occupied house is different from the formula used for the estimation of the value of an operating office building that is leased to several tenants.

In general, we can distinguish the Net Present Value formula that is used in association with the Discounted Cash Flow (DCF) model (mainly for income producing property), the sales comparison approach, used mainly for owner-occupied property but also for income-producing property as a second estimate to compare with the DCF approach result, and the residual method, which is typically used in valuing land plots with development potential. These methodologies and the respective property value formula used are examined below.

Property Value Formula for Income Producing Property

In order to estimate the value of an income producing property (for example an office property) we can use the Present Value (PV) formula, which is the following:

PV=CF₁/(1+r)+ CF₂/ (1+r)² +.........+CF_n/(1+r)ⁿ

where

CF₁= after-tax property cash flow in the first year of the life of the investment

r = rate of return required by investors or the discount rate used by investors in the local market for a comparable property

n= expected life of investment or holding period in number of periods

CF_n= after-tax cash flow during the last year n of the anticipated life of the investment, which is calculated taking into account, among others, the expected income of the property during that period, the expected resale price of the property, the repayment of the remaining loan balance and any tax consequences associated with the resale of the property.

A simplistic but less reliable calculation is based on the direct income capitalization approach, which uses the following formula:

Property Value= NOI / C

Where
NOI = net operating income of the property
C = market capitalization rate

Property Value Formula for Sales Comparison Approach

In the case of owner-occupied properties, like a home, the value of the property is typically calculated based on the sales prices realized recently by comparable properties in the neighborhood or local market within the property under valuation competes for buyers. This is the sales comparsion approach in valuation terminology, which implies a different property value formula. However, because no two properties are exactly the same, we usually need to adjust the sales prices of comparables properties upwards or downwards in order to perfectly reflect the quality of the property under consideration. In such a case we end up with a number of different estimates for the property under consideration since the appropriate adjustment of the sales price of each comparabe will not produce exactly the same value across comparables. In this case, the property value formula is simply the unweighted or weighted average of the Adjusted Comparable Prices (ACP) as follows:

Unweighted average property value formula:

PV =ACP₁ + ACP₂ + ........+ ACP_z / z

Where:
ACP₁ = Adjusted Comparable Price for Comparable 1
ACP_z = Adjusted Comparable Price for last Comparable z
z = total number of comparables used for the calculation of the value of the property under consideration

The weighted average property value formula should be used when the analyst wants to use different weights for some of the comparables because he/she feels that they better represent the property under valuation or because of more confidence in the price information provided for those comparables. In such a case the following formula can be used:

PV = w₁ * ACP₁ + w₂ * ACP₂ + ........+ w_z * ACP_z

Where:

w₁ = weight to be applied to Comparable 1 ACP
w₂ = weight to be applied to Comparable 2 ACP
w_z = weight to be applied to Comparable z ACP

Note that when determining the weights to be applied to each ACP the following condition MUST HOLD:

w₁ + w₂ +……….+ w_z =1

To demonstrate the application of this property value formula, consider that we have four comparable properties that are adjusted as follows in order to derive respective ACPs:

Comparable 1 with sale price of 120,000 is reduced 10% to 108,000 if it were to become exactly the same as the subject property

Comparable 2 with sale price of 100,000 is increased 10% to 110,000 if it were to become exactly the same as the subject property

Comparable 3 with sale price of 100,000 is increased 5% to 105,000 if it were to become exactly the same as the subject property

Comparable 4 with sale price of 110,000 is reduced 5% to 104,500 if it were to become exactly the same as the subject property

Therefore:

ACP₁ = 108,000
ACP₂ = 110,000
ACP₃ = 105,000
ACP₄ = 104,500

If we equally weight the information from the four comparables then we can use the unweighted averageformula to estimate the value of the property under consideration as:

PV = (108,000 + 110,000 + 105,000 + 104,500) / 4 = 106,875

If however we want to weight the information from Comparables 1 and 2 more than Comparables 3 and 4 because the former are in the immediate neighborhood of the property and the other two are not, then we may assign the following weights and estimate the weighted average as follows:

w₁ = 0.30
w₂ = 0.30
w₃ = 0.20
w₄ = 0.20

and

PV = 0.3*108,000 + 0.3*110,000 = 0.2*105,000 + 0.2*104,500
= 32,400 + 33,000 + 21,000 + 20,900 = 107,300

The sales comparison approach applies also to income producing properties if there are transactions available but the net present value approach should be given more weight when estimating the values of such properties because the future cash flow profile of any income producing property is usually idiosyncratic based on existing lease contracts and as such its market price and value cannot be fairly represented by any other comparable.

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