When purchasing a real estate property, there are 3 main approaches to valuation: (1) Price per sq. feet analysis; (2) Rental yield analysis; (3) Discounting cash flows
Purchasing a house is an important financial decision. Valuation refers to the price that is being paid for that property. It is absolute essential to diligence the price being paid for the property. Below are some metrics and analyses that can guide you through the pricing analysis.
1 Price per square feet
This is the most commonly used metric when analyzing real estate prices. It is calculated as the price of the property divided by the size of the property in sq. feet. One has to be careful about the size being used. Sometimes sellers add the amenities or other space components to the area of the house and call it ‘Built up area’ or ‘Super built up area’. As an example, if the value of the house is INR 25 lacs and the size of the house is 1,000 square feet then the price is INR 2,500 per sq. feet. Sometimes developers include the area outside the house and call this the built-up area. In the example above, say the Built-Up area is 1,200 sq. feet. The price per sq. feet if you consider Built up area becomes INR 2,000 per sq. feet. Developers at times use Super Built up area which includes several common area amenities into the area – In the example above, say the super built up area is 1,500 sq. feet. The price per sq. feet using super built up area becomes INR 1,666 per sq. feet.
Buyers should look at similar houses in the vicinity and see what the price per sq. feet for these houses is. These benchmarks should then be applied to the house is under consideration to buy. The buyers should also browse through property listing sites and see what the price per sq. feet metrics for similar houses are.
In some geographies price per sq. meter is also used. For some type of properties, price per square yard is also used.
2 Rental yield
Rents can give you an idea of the potential value of a house. The rental yield of an area does not differ much among the properties within that particular area. So, knowing the rent of a similar house can help you determine the house value of the residential property under consideration. As an example, if rental yield in the area is 3% and the rent for a house in that area is INR 75,000 per year (that is, INR 6,250 per month) then the price of that house is 75,000 divided by 3% which equals INR 25 lacs.
3 Discounting cash flows
This is a complex exercise and is mainly done for commercial real estate. In this exercise cash flows are forecast for each year going forward and then discounted to arrive at present value by using a target return rate. This approach is technical and is used mainly for large commercial real estate transactions.
Investors should use all the three approaches mentioned above and arrive at a range of valuation for the real estate property being considered.
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