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Real Estate Valuation

Real Estate Valuation. Real estate valuation is an elaborate process which determines the true monetary value of an real estate investment. Many terms are used in real estate valuation such as net real estate income, fair market value, and net worth. The capitalization ratio is a primary metric for determining the value of an income producing real estate.

Net operating earnings (NOI) calculates the profitability of an investment before taking additional expenses for taxes and financing. In real estate appraisal, other major considerations include: location, condition, price, land or building, and comparable properties in the immediate area.

Many real estate appraisal methods have evolved since W. Clement Stone's published The Geographical Analysis of Value in 1761. A method called Fluctuation is one such method. Fluctuation suggests that value varies with location. There are certain time periods when an area has higher or lower values compared to the rest of the time period. While the standard deviation shows the standard deviation of the random variables, the condition-specific deviation shows the variations within individual time intervals.

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Another method of real estate valuation that shows significant relationships with geographic location and net operating income is known as geometric mean approach. Geometric mean draws a random sampling of data and divides it into smaller areas. Areas which have high or low values throughout the entire range of the distribution are drawn as being very similar in shape to each other and as being very dissimilar from those with low values. The mean of these area boundaries is then used as the basis for calculating the property's value.

Another common real estate valuation method that helps identify good investment properties is referred to as discounting. This method differs from geometric mean in that it omits the effect of time on value determination. Instead of looking at current and future income from the property, discount rates incorporate the discount a investor will receive if selling the property in the future.

This makes the process of comparing properties for discount rates quite complicated, but it can be simplified by looking at it from an investor's point of view: what is the value of the discounted value of the real estate now? Given this information, how should an investor go about purchasing a real estate at a discounted price?

One way to overcome the difficulty associated with calculation of discounted rates is to look at real estate valuation models. These valuation models were developed by real estate experts to aid in the calculation of discounted returns. Basically, real estate valuation models help investors make sense of the complex real estate market and identify where and when they should purchase properties. Most real estate valuation models focus on using historical data to calculate the discounted value.

There are two types of real estate valuation models: the market value and the relative value. The market value is the most widely used and the easiest to understand, since it involves only the sale prices. Relative value on the other hand is much more complex as it takes into consideration such factors as land and building structures. For instance, it takes into account whether a particular property will appreciate or depreciate in time. The use of relative value is also affected by the time period used for calculating it: the longer time frame used, the less room there is for error.

Real estate investors must decide what kind of discount rate to use. The discount rate used is either the arithmetic mean of the discounted cash flow or the multiple-period discounted cash flows. The arithmetic mean uses the level of net income and reinvestment that is required in order to generate a net income and so requires very low reinvestment requirements. The multiple-period discounted cash flows requires higher reinvestment levels in order to generate a higher net income. This requires higher capitalization rates as well. It also has the potential to yield very high returns.

It is also important to note that the valuation method that is chosen depends entirely on the purpose of the investment. For instance, an investor who aims to earn rental income will use a different valuation method from one who is looking at generating mortgage or capital gains income. It is therefore best to understand your own goals when choosing the appropriate real estate valuation method.

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