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Glossary valuation methods:

MatthiasKirchner | Expert on real estate appraisal | Real estate valuer

 

1. Valuation method
2. Overview of valuation methods
3. Standardized methods
4. Not standardized methods
5. The right choice of methods

  1. The valuation methods

    The methods for the appraisal of property values have been developed within several decades or centuries. As the property values are needed regularly in order to pay taxes or to control market actions, adequate methods for the evaluation of property values are of need, too. With the influences of public, economic or legal incidents and regulations to the property values, the methods have been improved, adjusted and substantiated. Different legal forms of real estate property, different economic models with own assessments of value and own property markets leading to different valuation methods, arose. The internationalization of land transactions, the growing together of markets and the construction of economic units as the European Union made it necessary to internationalize and harmonize valuation methods.


  2. Overview of valuation methods

    All known methods try to exemplarily demonstrate the pricing of the market participants on the property market. As there exists no absolutely right property value within a market economy, all methods can only approximately lead to a value which is in accordance with the market.

    The results of the methods must be counter-checked with the property market and adjusted, if necessary. It is also of need to regularly control the different parameters and influences of the models and to counter-check (adjust if necessary) with the real accumulation of value on the property market.

    The property market is influenced by numerous visible, invisible, objective and subjective, putative and right factors. Therefore, it is impossible, to find the one right method or to consider all influences.

    The models of valuation methods are field-tested and require a substantial knowledge of technical, economic and legal aspects. All attempts, to find out a universal and general formula of property valuation by complicated mathematical and statistical methods, failed. To develop extensive models of the real estate market, did not succeed, either. It seems almost impossible to develop mathematical models which adapt to the changes of the market and which meet the requirements of the fair market value and its definitions. Simple market models are not sufficient.

    In Germany, during several years, methods were developed which are legally fixed by the so-called German federal ordinance for valuation (WertV). Other European countries do not have a legal norm of valuation methods. Here, the know-how and experience of experts on real estate appraisal is required. In order to harmonize the European systems, the experts settled a cooperation and recommendation agreement. In general, there will be no standard of real estate appraisal within the European Union.


  3. Standardized valuation methods

    In Germany, the valuation of properties is legally fixed by the German federal ordinance for valuation (WertV). The German federal ordinance for valuation defines three valuation methods:

    • the comparable method of valuation (13—14 WertV)
    • the investment capitalization valuation method (§ 15 —20 WertV)
    • the asset value method (21 — 25 WertV)


    The use of standardized methods could either be regulated by law or is used as it is guaranties a precise view of the property market. All authorities, courts, institutions and experts, effecting appraisals in the field of the German federal building code (BauGB) and the German federal ordinance for valuation (Wert V) are bound to these methods by law.

    As in Germany these three methods have been established over a long period of time, they are used even without legal force for numerous appraisals. A special reason for this is the number of market data and analyses existing for the different parameters of the methods.

    Primarily, there should be decided which method or which combination of all three methods to use. The first and most important step of the determination of fair market value is the right choice of methods. As first orientation serves the consideration of a fictitious seller or purchaser of a property. Depending on the property, different criteria have to be evaluated which determine the choice of methods. Of course there are principle points for the three valuation methods, which arise out of the market behaviour of the property market’s participants. However, it might be necessary to combine several methods. Indeed, the wrong method – as it often can be found in experts’ reports – is to take the arithmetic mean of two methods in order to find out the fair market value. It is not that easy.

    In many cases, several methods are shown in the surveys although only one method can come to the right result. It is often said that the regulations for architects’ and engineers’ fees (HOAI) are the reason for this proceeding. The HOAI fixes that the use of only one valuation method causes a 20 % deduction of the expert’s fee.

    The comparable method of valuation is the best and most precise method of valuation. It can be applied to all property submarkets and together with the comparison of real property purchases leads to the most precise results. Unfortunately, often the number of comparable properties is not sufficient. The German digital property transactions inventory of the board of expert valuers should be used, as far as possible. In addition to the comparison of purchase prices, the so-called comparable factors valuation is possible. This simplifies the use of the comparable method of valuation and makes it safer. Should it not be possible to use the comparable method of valuation, the other two methods will be taken into consideration.

    The investment capitalization valuation method is used for properties, which price or value depends on the yield or the return. For the market participant, the focus lies on the possibility of gaining a return when putting capital into the property. This does not depend on individual interests of a potential buyer, but only on the general consideration of the market. Examples for real estate, where mainly the yield is taken into consideration, are: all rental apartment blocks (even if there is a high percentage of commercial use), commercially used buildings which are rented (office and administration buildings, shopping centres).

    The evaluation of individual apartments of a property block or of undeveloped sites by means of the investment capitalization valuation method does not come to a precise result. The consideration of the property on the property market, which can be different, depending on the region, is the most important fact. Here, the knowledge of the expert is required, too.

    Comparable to the investment capitalization valuation method, the asset value method is to be used. When choosing this method for property appraisal, the property market is also the most important aspect. If the focus lies on the property and not on the yield, the asset value method will be used. The main point of this method is the value of the property as well as the value of the building. The value of the building structure will be appraised and leads to the asset value.

    This method is used for the evaluation of single-family houses and houses with two apartments (due to the owner occupation), but it is also applied to industrial sites or buildings, plant buildings and buildings with special use as there are gyms, schools, hospitals or shopping centres.
     
    When choosing the asset value method, there must be found out, if the property value depends on the structure or the yield. Often, it is difficult to clearly assign to one method – consequently, both valuation methods are used. Then, the fixing of the fair market value must be well-founded and reasonably justified.

    The three methods are also used for the evaluation of home ownership (part ownership, too). In this case, it must be clear that all influencing factors have been worked out for the submarket of the ownership and part ownership.

    When describing the methods in the following paragraphs, the evaluation of home ownership is taken into consideration as well as the appraisal of other valuation aspects as there are:

    • Property rights of all kinds
    • Compensation for land taken by compulsory purchase
    • Compensatory amounts for urban redevelopment programmes and urban development areas


    4.   Not standardized methods

    In Germany, methods which are not standardized but have become important, are based on business management models, similar to the investment capitalization valuation method. These new methods, the so-called “Anglo-Saxon“ or „International“ valuation methods, have led to various intensive discussions which method to be the right one. In many cases, the not standardized methods were considered to be better. Critics who did not like the results of various appraisals, explained this by the methods, being used.

    Even when applying to standardized methods, many experts neglected the economic approach of a property as they acted on the assumption of a static durability of a property. Meanwhile, it has shown that all methods are models which try to follow all aspects of pricing on the property market. Among all not standardized methods, in other European countries methods exist which are similar to the German standardized methods. Even the often called “better” American methods are related to the standardized methods in Germany.

    Methods which in Germany became important in the course of the last years:

    • the development appraisal,
    • the discounted cash flow method (DCF)
    • the Monte Carlo simulation
    • the investment method.


    5.   The right choice of method

    The first and most important step of the determination of fair market value is the right choice of methods. The consideration of a fictitious seller or purchaser of a property serves as a first orientation. Depending on the property, different criteria have to be evaluated, which determine the choice of methods. Of course there are principle points for the three methods, which arise out of the market behaviour of the property market’s participants. However, it might be necessary to combine several methods. Indeed, the wrong method – as it often can be found in experts’ reports – is to take the arithmetic mean of two methods in order to find out the fair market value. It is not that easy.

    The first step is to decide whether to use a standardized or not standardized method. A standardized method has to be used if the German federal ordinance for valuation is basis for the evaluation and therefore, the evaluation is bound to the German administrative regulations for valuation. This could be the case within authorities or if the evaluation is ordered by authorities. But also courts put emphasize on the methods of the „WertV“ and often include this in their evidence orders. Every evaluation, based on the German federal building code (Bau GB), German federal ordinance for valuation (WertV) and German administrative regulations for valuation (WertR) can only be made by standardized methods.

    Not standardized methods can be applied in cases of valuations of investments and projects, especially, if the expert’s customer is not legally bound.

    Then, it has to be decided, which method to use:

    The comparable method of valuation is the best and most precise method of valuation. It can be applied to all property submarkets and together with the comparison of real property purchases leads to the most precise results. Unfortunately, often the number of comparable properties is not sufficient. The German digital property transactions inventory of the board of expert valuers should be used, as far as possible. In addition to the comparison of purchase prices, the so-called comparable factors valuation is possible. This simplifies the use of the comparable method of valuation and makes it safer. Should it not be possible to use the comparable method of valuation, the other two methods will be taken into consideration.
    The investment capitalization valuation method is used for properties, which price or value depends on the yield ort he return. For the market participant, the focus lies on the possibility of gaining a return when putting capital into the property. This does not depend on individual interests of a potential buyer, but only on the general consideration of the market. Examples for real estate, where mainly the yield is taken into consideration, are: all rental apartment blocks (even if there is a high percentage of commercial use), commercially used buildings which are rented (office and administration buildings, shopping centres)

    The evaluation of individual apartments of a property block or of undeveloped sites by means of the investment capitalization valuation method does not come to a precise result. The consideration of the property on the property market, which can be different, depending on the region, is the most important fact. Here, the knowledge of the expert is required, too.

    Comparable to the investment capitalization valuation method, the asset value method is to be used. When choosing this method for property appraisal, the property market is also the most important aspect. If the focus lies on the property and not on the yield, the asset value method will be used. The main point of this method is the value of the property as well as the value of the building. The value of the building structure will be appraised and leads to the asset value.

    This method is used for the evaluation of single-family houses and houses with two apartments (due to the owner occupation), but it is also applied to industrial sites or buildings, plant buildings and buildings with special use as there are gyms, schools, hospitals or shopping centres.
     
    When choosing the asset value method, there must be found out, if the property value depends on the structure or the yield. Often, it is difficult to clearly assign to one method – consequently, both valuation methods are used. Then, the fixing of the fair market value must be well-founded and reasonably justified.  When using not-standardized methods, it has to be decided, for which purpose the appraisal is made.


    The development appraisal: The development appraisal is used in all cases of a planned investment. It guarantees an overview of the profitability of the investment (a new building, a modernization, servicing or a change of use)

    Discounted cash flow method (DCF): The appropriate method for the consideration of the value development within a determined period of time, is the DCF method. It takes into consideration possible costs, returns, investments, services and maintenances as well as market changes.

    Monte Carlo Simulation: The Monte Carlo method enables the expert to vary insecure and unknown elements of the return and the yield of a property and therefore to calculate them by means of a mathematic and statistic model. This method is suitable for the calculation of planned investments.

    Investment method: this method also measures planned investments on a property and takes into consideration future developments and influences on the yield and the costs. By this method the investments and their profitability can be controlled.
    In any case, the choice of method or methods has to be explained in detail in the expert’s report. This will be of special importance, if more than one method is used.