REAL ESTATE VALUATION

Introduction
• Real estate valuation is also called real estate appraisal. It is the art and science that
involves expert determination of the value of real estate property.
• Such valuation is often done by a land valuer, a property valuer or realotors.
• The valuation is necessary because:

i. Real estate is heterogeneous in nature- no two properties are exactly identical.

ii. Real estate values depend on locations which are diverse.
iii. There is no real estate market-based pricing mechanism.

• There are several types and definitions of value in real estate appraisal:

i. Value-in-use – The net present value (NPV) of a cash flow that a real estate asset
generates for a specific owner under a specific use. Value-in-use is the value to one
particular user, and may be above or below the market value of a property.
ii. Market Value –The International Valuation Standards (IVS) define market value
as the estimated amount for which a property should exchange on the date of
valuation between an educated buyer and a reasonably motivated seller in an arms-
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 length transaction after proper marketing wherein the parties had each acted
knowledgeably, prudently, and without undue influence.
iii. Investment value - is the value to one particular investor, and is usually higher than
the market value of a property.
iv. Insurable value - is the value of real property covered by an insurance policy.
Generally, it does not include the site value.
v. Liquidation value – Is a value useful during bankruptcy and liquidation
proceedings. Liquidation may be analyzed as either a forced liquidation or an
orderly liquidation and is a commonly sought standard of value in bankruptcy
proceedings. It assumes a seller who is compelled to sell after an exposure period
which is less than the market-normal time-frame.

Methods of Real Estate Valuation

The most common approaches to valuation include:
i. The cost approach
ii. The sales comparison approach
iii. The income approach
iv. Market rent
v. Market value
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vi. Fair value

The Cost Approach

• The value of a property can be estimated by summing the land value and the depreciated
value of any improvements.
• The value of the improvements is called replacement cost new less depreciation-
RCNLD.
• The replacement cost is the cost of building a house or other improvement which has the
same utility, but using modern design, workmanship and materials.
• The cost approach is considered reliable when used on newer structures, but the method
tends to become less reliable for older properties.
• The replacement cost approach is easier to implement since it is based on the current
construction costs. It however has the following limitations:

i. it requires land appraisal which is quite difficult to implement.

ii. The market value of a property may differ radically from the construction cost. For
instance, the value could be derived from the location, type of tenants etc which may
have no bearing on the construction cost.
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Illustration:
ABC Ltd had been an investor in the real estate sector for a long time. On January 1, 2014,
the company acquired a piece of land in the Kitengela area in Nairobi’s suburbs at
Sh.5,000,000. The property remained idle to December 31st 2017 when the property value
had appreciated to Sh.7,000,000 in market value terms. A rental house was put up in the
course of the year 2018 it cost the following inputs:
Construction materials Sh.2,500,000
Labour Sh.1,500,000
In addition, construction overheads were ascertained at 40% of all the direct inputs into
construction. The company intended the house to be useful for 40 years whereupon it could
be scrapped at Sh.1,120,000. Construction costs are depreciated on a reducing balance
basis. Determine the value of the real estate property at 31.12.2021 using the cost method,
with the replacement cost new less depreciation approach if the following property price
indices are relevant:
1.1.2014 1,050
31.12.2014 1,260
31.12.2017 1,890
31.12.2018 2,268
31.12.2021 3,402

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Description Index Sh. (Index) Sh Sh
Land 1.1.2014 3402/1050*5,000,000 16,200,000
Building 2018 Materials 2,500,000
Labour 1,500,000
Direct cost 4,000,000
Overheads 40% 1,600,000
Total cost 5,600,000 3402/2268*5.6m 8,400,000
Total cost 24,600,000
Depreciation 2019: 0.0394*5,600,000 220,640
2020:0.0394(5,600,000 - 220,640) 211,947
2021:0.0394(5,600,000 - 432,587) 203,596 (636,183)
RCNLD 23,963,817

𝑺𝒂𝒍𝒗𝒂𝒈𝒆
𝒏 𝟒𝟎 𝟏, 𝟏𝟐𝟎, 𝟎𝟎𝟎
𝑹𝑩𝑫 = 𝟏 − √ = 𝟏− √ = 𝟎. 𝟎𝟑𝟗𝟒
𝑪𝒐𝒔𝒕 𝟓, 𝟔𝟎𝟎, 𝟎𝟎𝟎

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The Sales Comparison Approach
• The approach involves examination of the price per unit area of similar properties being
sold in the market place.
• The sales of properties similar to the one under appraisal are analyzed and the sale price
adjusted to account for differences with the property to determine the value.
• The market value is estimated relative to a benchmark value.
• It is based on the principle of substitution with the assumption that a prudent individual
will pay no more for a property than it would cost to purchase a comparable substitute
property.
• The approach recognizes that a typical buyer will compare asking prices and seek to
purchase the property that meets his or her wants and needs for the lowest cost.
• Various steps are used in the sales comparison method. These include:

i. Market research for information regarding sales, listings and pending sales of similar
properties. Data may be sourced from real estate publications, public records, buyers,
sellers, real estate brokers and/or agents, appraisers, etc.
ii. Analysis of the market data for their correctness and factual accuracy
iii. Determination of the units of comparison e.g. sales per square foot

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 iv. Comparison of the property under valuation and comparable units for adjustment.
Since comparable sales are not usually identical to the subject property, adjustments
may be made for date of sale, location, style, amenities, square footage, site size, etc.
v. Reconciliation of the multiple value indications that result from the adjustment of the
comparable sales into a single value indication.

• Despite the objectivity inherent in the approach, there are numerous limitations:

i. There is need to adjust the benchmark estimate for changing market conditions
ii. The benchmark itself may be overpriced or underpriced
iii. Properties with comparable characteristics might not have traded recently.

• To overcome these limitations, a common approach is to use hedonic price estimation in

the sales comparison approach.
• According to the hedonic price estimation, the following steps apply:

i. The major characteristics of a property that can affect value are determined. These
could be:

▪ The age of the building

▪ The size of the building
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 ▪ The location of the building
▪ The vacancy rate
▪ The amenities available in the building, etc

ii. Individual properties are awarded a quantitative rating for each of the characteristics.
For instance, the factor rating for every characteristic may range from 1 (very bad)
to 10 (excellent).
iii. The sales prices for all the recent transactions of the properties in the benchmark are
regressed on their characteristics’ ratings. It is a regression analysis in which there
is one observation for each transaction. Here the dependent variable is the
transaction price while the independent variables are the ratings for each of the
characteristics.
iv. The Estimated slope coefficients are the valuations of each characteristic in the
transaction price. This gives a benchmark monetary value associated with each
characteristic rating.
v. The selling price of a specific property is estimated by taking into account its rating
on each feature.

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Illustration:
A real estate company has prepared a simple hedonic model to value houses in Buruburu
area of Nairobi. A summary list of the houses’ characteristics that can affect pricing are:
▪ The number of rooms in the house
▪ The surface area of the garden
▪ Presence of a swimming pool
▪ Distance to the shopping center

A statistical analysis of a large number of recent transactions in the area allowed the
company to estimate the following slope coefficients:
Characteristics Units Slope Coefficent in Ksh/Unit
The number of rooms number 200,000
Garden surface area Sq. feet 5
Swimming pool 0 or 1 200,000
Shopping center Distance km -100,000

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A typical house in the area has five main rooms, a garden of 100,000 square feet, a
swimming pool and a distance of 1 km to the nearest shopping centre. The transactions
price of a typical house is Sh.1,600,000.

Required: The appraisal value of a house with 7 rooms, a 10,000 square feet garden, a
swimming pool and a distance of 2km to the shopping centre. Use sales comparison
approach of the hedonic price estimation.

𝑉 = (20000 ∗ 𝑅𝑜𝑜𝑚𝑠) + (5 ∗ 𝐺𝑆𝐴) +∗ (𝑃𝐴𝑆𝑃 ∗ 200,000) − (100,000 ∗ 𝑑𝑖𝑠𝑡𝑎𝑛𝑐𝑒)

𝑉 = (200000 ∗ 7) + (5 ∗ 10,000) +∗ (1 ∗ 200,000) − (100,000 ∗ 2)
𝑉 = 1,400,000 + 50,000 +∗ 200,000 − 200,000 = 𝑆ℎ. 1,450,000

Illustration
The following factors have been identified to determine property values in Juja: Building
Structure, Type of roofing and Amenities. Recent sales of houses in Juja have involved
three houses owned by Tom, Dick and Harry at Sh.5 million, Sh.4 million and Sh.6 million
respectively.
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Hedonic factor ratings on a 1 (poor) to 5 (excellent) scales for the houses were determined
as:

Factor Tom Dick Harry

Building Structure 5 4 3
Type of roofing 1 2 5
Amenities 3 1 2
Use hedonic price estimation to determine the value of a house which has been rated as
follows on the respective factors: Building Structure, 3.5; Type of roofing, 3.0 and
Amenities, 2.5

𝐿𝑒𝑡 𝐵𝑢𝑖𝑙𝑑𝑖𝑛𝑔 𝑠𝑡𝑟𝑢𝑐𝑡𝑢𝑟𝑒 𝑏𝑒 𝑋

𝐿𝑒𝑡 𝐵𝑢𝑖𝑙𝑑𝑖𝑛𝑔 𝑟𝑜𝑜𝑓𝑖𝑛𝑔 𝑏𝑒 𝑌
𝐿𝑒𝑡 𝐵𝑢𝑖𝑙𝑑𝑖𝑛𝑔 𝐴𝑚𝑒𝑛𝑖𝑡𝑖𝑒𝑠 𝑏𝑒 𝑍

5 = 5𝑋 + 𝑌 + 3𝑍
4 = 4𝑋 + 2𝑌 + 𝑍
6 = 3𝑋 + 5𝑌 + 2𝑍
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Eliminate Y from first equation:
𝑌 = 5 − 5𝑋 − 3𝑍

4 = 4𝑋 + 2(5 − 5𝑋 − 3𝑍) + 𝑍
6 = 3𝑋 + 5(5 − 5𝑋 − 3𝑍) + 2𝑍

4 = 4𝑋 + 10 − 10𝑋 − 6𝑍 + 𝑍
6 = 3𝑋 + 25 − 25𝑋 − 15𝑍 + 2𝑍

−6 = −6𝑋 − 5𝑍 − − − − ∗ −13
−19 = −22𝑋 − 13𝑍 − − − ∗ −5

78 = 78𝑋 + 65𝑍
95 = 110𝑋 + 65𝑍

17 = 32𝑋
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𝑋= = 0.53
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 𝐵𝑢𝑡 6𝑋 + 5𝑍 = 6

𝐻𝑒𝑛𝑐𝑒 5𝑍 = 6 − (6 ∗ 0.53) = 2.82

2.82
𝑍= = 0.56
5

𝑌 = 5 − 5𝑋 − 3𝑍 = 5 − (5 ∗ 0.53) − (3 ∗ 0.56) = 0.67

𝑉𝑎𝑙𝑢𝑒 = (3.5 ∗ 0.53) + (3 ∗ 0.67) + (2.5 ∗ 0.56) = 𝑺𝒉. 𝟓, 𝟐𝟔𝟓, 𝟎𝟎𝟎

The NOI Capitalization Approach

Use of revenue multipliers or capitalization rates applied to the first-year Net Operating
Income (NOI)
NOI is the earnings before interest, depreciation and tax (EBIDT)
NOI = GPI - Vacancy and Collection loss- Operating expenses

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 𝑁𝑂𝐼
𝑁𝑂𝐼 𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 𝑉𝑎𝑙𝑢𝑒 =
𝑀𝐾𝑅
Where MKR is the market capitalization rate.
𝐵𝑒𝑛𝑐ℎ𝑚𝑎𝑟𝑘 𝑁𝑂𝐼
𝑀𝐾𝑅 =
𝐵𝑒𝑛𝑐ℎ𝑚𝑎𝑟𝑘 𝑃𝑟𝑖𝑐𝑒
GPI is gross potential income
The market capitalization rate is the rate used by the market in recent transactions to
capitalize future incomes to the present value.
MKR = Benchmark NOI/Benchmark Transaction price
The long-term value could be affected by changes in inflation rates which affect NOI. The
method also ignores the tax implications on the value of the real estate property.
NB: The operating expenses exclude debt service, income taxes, and/or depreciation
charges applied by accountants.

NB:

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 i. Financing costs are ignored to determine the value independent of the source of
finance
ii. Depreciation is taken as necessary to maintain the building in good condition, hence
it is ignored.

Illustration:
An investor wants to appraise an apartment complex in Kilimani area of Nairobi using the
Capitalisation of NOI approach. Recent sales in the area consist of an office building and
an apartment complex. The following data relate to the apartment and recent sales in the
area. Incomes are on an annual basis.
Gross expected rental income 3,432,000
Expected vacancy and collection losses 7.50%
Insurance and taxes 286,000
Utilities 200,200
Maintenance 343,200
Depreciation 400,400
Interest on proposed financing 314,600

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The net operating incomes on the recent sales of the office building and apartment complex
are Sh. 6,000,000 and Sh.1,500,000 respectively. The selling prices of those properties
were Sh.40m and Sh.12m respectively.
𝐵𝑒𝑛𝑐ℎ𝑚𝑎𝑟𝑘 𝑁𝑂𝐼 1,500,000
𝑀𝐾𝑅 = = = 0.125 = 12.5%
𝐵𝑒𝑛𝑐ℎ𝑚𝑎𝑟𝑘 𝑃𝑟𝑖𝑐𝑒 12,000,000

Sh Sh.
Gross rental Income 3,432,000
Expenses
Vacancy losses 7.5% 257,400
Insurance and taxes 286,000
Utilities 200,200
Maintenance 343,200 (1,086,800)
NOI = EBIDT 2,345,200
Divide by MKR ÷0.125
Value 18,761,600

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The Discounted Cash Flow Approach
Value is taken as the PV of cash flows from a property to an equity investor discounted at
the investor’s required rate of return on equity, less the amount of equity required to make
the investment. A good equity investment must have a positive NPV.
The technique applies market-supported yields (or discount rates) to future cash flows
(such as annual income figures and typically a lumpsum reversion from the eventual sale
of the property) to arrive at a present value indication.
Illustration
A real estate investment has a purchase price of Sh.5m. It is 20% financed by equity, the
remainder being mortgage finance at 15% pretax interest rate. The mortgage is a fully
amortized loan repayable in 24.57 years with instalments due at the end of every year. The
NOI in the first year is Sh.850,000 and is expected to grow at 6%p.a. Depreciation is at
Sh.187,000 p.a.
Required:
i. A loan amortization schedule over the first 3 years

𝐿𝑜𝑎𝑛
𝐿𝑜𝑎𝑛 𝐼𝑛𝑠𝑡𝑎𝑙𝑚𝑒𝑛𝑡 =
𝑃𝑉𝐼𝐹𝐴15,24.57
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 1 − (1 + 𝑟)−𝑛 1 − (1 + 0.15)−24.57
𝑃𝑉𝐼𝐹𝐴 = [ ]=[ ] = 6.4516
𝑟 0.15

0.8 ∗ 5,000,000
𝐿𝑜𝑎𝑛 𝐼𝑛𝑠𝑡𝑎𝑙𝑚𝑒𝑛𝑡 = = 𝑆ℎ. 620,000
6.4516

Mortgage Amortization Schedule

Year Balance bf Instalment Interest 15% Loan Repaid Balance cf
0 - - - - 4,000,000
1 4,000,000 620,000 600,000 20,000 3,980,000
2 3,980,000 620,000 597,000 23,000 3,957,000
3 3,957,000 620,000 593,550 26,450 3,930,550

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ii. The first 3 years’ after tax cashflows given that the tax rate is 30%
NCF
Year 1 (Sh.) Year 2 (Sh.) Year 3 (Sh.)
NOI=EBIDT 850,000 901,000 955,060
Depreciation (187,000) (187,000) (187,000)
EBIT 663,000 714,000 768,060
Interest (600,000) (597,000) (593,550)
EBT 63,000 117,000 174,510
Tax -30% (18,900) (35,100) (52,353)
EAT 44,100 81,900 122,157
Add Back Depreciation 187,000 187,000 187,000
NCF before loan repayment 231,100 268,900 309,157
Loan repaid (20,000) (23,000) (26,450)
Full NCF 211,100 245,900 282,707

iii. The property is sold at the end of the third year. Compute the after tax cash flows
given the following information:
• Sales expenses as a percentage of sales price 6.5%
• Forecasted sales price 6,500,000
• Capital gains tax rate 30%
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 Net Cash flows from Sales
Sh. Sh. Sh. Sh.
Disposal price 6,500,000
Disposal expenses 6.5% 422,500
Outstanding Loan 3,930,550
Capital gains:
Disposal value 6,500,000
Disposal expenses (422,500)
Net Disposal value 6,077,500
Cost 5,000,000
Less Depr (187,000*3) (561,000) (4,439,000)
Capital gains tax 30% 1,638,500 491,550 (4,844,600)
NCF from disposal 1,655,400

iv. If the required rate of return is 20%, should this investment in real estate property be
undertaken? Use NPV analysis

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 Year NCF PVIF20,t=(1+0.2)-n PV
1 211,100 (1.2)-1=0.8333 175,910
2 245,900 (1.2)-2=0.6944 170,753
3 282,707 (1.2)-3=0.5787 163,603
3 1,655,400 (1.2)-3=0.5787 957,980
Sum of PV 1,468,246
Less I0=20% of 5m (1,000,000)
NPV 468,246

Decision: Since NPV is positive, the investment s desirable.

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