Perspectives on the valuation of real estate properties in the current market
Valuation Services Insights
Ever since the real estate market started functioning after the '90s, the comparable sales and the rent capitalization methods have produced widely different results. The wide gap between the values derived under comparable sale and rent capitalization method could be explained, by the existence of additional income sources, that Albanian households have, apart from wages.
In the last–year–and–a–half, while engaged in real estate appraisals throughout the country and in casual discussions with valuation experts and bankers, a number of questions have often come up related to real estate values in the current market landscape. “How is market value determined in a dried up market?” or “Why isn’t the capitalization of rent method utilized as the primary valuation method for an apartment, store, or land?” With this article, I intend to share a few perspectives and thoughts related to these questions, while simultaneously hoping to stimulate a broader discussion on the topic from all players in the real estate sector.
The price of any good or service, by definition, manifests the precise intersection between supply and demand. But, is the price–setting mechanism currently working for real estate properties in Albania?
We’ve been witnessing a significant reduction in the number of property transactions in the entire country, even in the most popular and exclusive real estate areas in major cities.
When no transactions take place at a time when the desire to buy or sell can clearly be evidenced--for example, by the number of offers to sell or the number of requests to buy--suggests that a material divergence exists between the buyers’ and sellers’ market positions, and, for all intents and purposes, neither is willing to move toward the others’ direction. The entire concept of market value is built on the premise of a willing and able seller and a willing and able buyer, both of whom agree to enter into an agreement to exchange property on a specific date. Because a seller is not willing to sell a property at the price currently offered by the buyers, or because a buyer postpones a transaction under the expectation that prices will decline and therefore it is better to wait, the notion of market value is overwhelmed.
Under these settings, how would an appraiser assess the market value of a property when a market comprised of willing sellers and buyers is very thin or does not even exist? A good approach is for the appraiser to begin the valuation process by analyzing empirical, fundamental factors from both a micro– and macro–economic perspective, to arrive at a probabilistic estimate that most closely resembles the equilibrium “supply meets demand”.
From a micro economic view
1. – From a micro–economic view, market value is determined using generally accepted valuation methods, the most commonly used of which is the comparable sales method. Turning to what we just said previously, however, it means that the comparable sales method is not sufficient to arrive at the market value because actual sales transactions may not exist or are stale. Another universally used method in the valuation of real properties is the capitalization of rent method, albeit it is not typically applied or relied upon for residential properties in Albania. Ever since the real estate market started functioning after the '90s, the comparable sales and the capitalization of rent methods have concluded in widely different results. I will illustrate this with a simple example.
A furnished apartment with an average area of 70–80 m2 located in Tirana’s very own city center is rented for around EUR 250–300 /month, although it is presumed that it would sell somewhere in the range of EUR 1,000 – 1,200 per m2. Without taking into consideration any necessary adjustments to the actual rent price, such as adjustments for vacancy rates, contribution of furniture to rent, or differences between used area to total area, rent for m2 would be EUR 3.6–3.8 per month, or EUR 43–45 annually. The derived relationship between annual rent and the sales price results in what is known as the yield (rate of return on capital). In our example, this would equal 3.8% (45/1,200) to 4.3% (43/1,000). Since yield is also used as an indicator of investment risk, this places Tirana on the same footing as other major metropolitan cities such as London, Paris, and Berlin. But that is simply not true.
Based on a risk analysis of real estate investments in Tirana, it appears that under the current market conditions, but also based on medium–term forecasts, the yield is 10%–12%. Capitalizing the prevailing market rent using this yield results in values placing in the 375–430 EUR/m2 range, a figure that is fairly close to the average construction costs in Tirana, and 3 to 4 times less than the property sales prices. This phenomenon is also observed to persist in other countries of the region. A number of perfectly valid reasons exist, including people’s crave to own property as opposed to the less desirable psychological condition of living on someone else’s property; the perceived uncertainty related to long–term rent contracts (i.e., the risk that the landlord may suddenly interrupt the rental agreement or seek to place the property on sale); or the appeal of securing another source of income apart from wages.
From a macro economic view
2– In order to appropriately assign weightings to each of the two above–mentioned methods, we should now turn our attention to a macro–economic perspective. At the broad economic level, the real estate market is analyzed on the basis of several parameters, the most important of which are:
(1) the house price to income ratio is the basic affrodability measure for housing in a given area. It is generally the ratio of median house prices to median familial disposable incomes, expressed as a percentage or as years of income. This long–term, closely monitored ratio suggests that the home price which can be afforded by a family is equivalent to 3–4 times their annual income;
(2) the deposits to income ratio is the minimum required downpayment for a typical mortgage, expressed in months or years of income;
(3) the affordability index measures the ratio of the actual monthly cost of the mortgage to take-home income. It is used more in the United Kingdom where nearly all mortgages are variable and pegged to bank lending rates. It offers a much more realistic measure of the ability of households to afford housing than the crude price to income ratio. However it is more difficult to calculate, and hence the price to income ratio is still more commonly used by pundits.
(1)i. The average household income is defined as gross income from all sources, including wages, incomes from businesses and other activities, incomes from investments, and benefits in kind, such as consumption of agricultural products.
ii. Average (median) house price: an average–priced property is defined for purposes of this ratio as a property below which 50% of properties have a lower price and above which 50% of properties have a higher price. Value is defined as the price at which the property would sell after a reasonable marketing period and by a seller who is under no compulsion to sell.
Perspectives on the valuation of real estate properties in the current market
The charts above show the historical trend of the house price to income ratio during the period 1976 – 2011 and its distribution across Europe in 2015. The long–run average of this ratio equals 3.5 times annual earnings, while in the recent years is has trended toward the 5.0–5.5 times territory. In the chart to the right, the green symbols represent a lower figure and the red symbols represent a higher figure as compared to the 3.5 average.
The mean earnings of an Albanian household are estimated to be ALL 60 to 65 thousand per month (EUR 430–465 per month), or EUR 5,143 to 5,571 per year. These earnings include almost exclusively wages, as there are no reliable statistical data related to other income sources of a household. By applying the house price to long–term annual income based on a 5–6x years ratio, the average price afforded by a family would range between EUR 25,700 – 33,400. If the average required space for a typical family would vary between 70–80 m2, the price per m2 that a family would afford is EUR 367 – 418. This price range is very close to the results under the capitalization of rent method.
The wide gap between the values derived under the comparable sales method and the capitalization of rent method could be explained, in part, by the existence of additional income sources that Albanian households have apart from wages.
Conclusion: As long as actual transactions exist, market values of real estate properties will appropriately be determined on the basis of those transactions, regardless of the composition and sources of household income. To the extent household income grows smaller, then the value of real estate properties will begin to get closer to the intrinsic (affordable) values implied by household wages. Additionally, there will be a reduction in the number of transactions. In these conditions, the capitalization of rent method will be awarded a greater weight in the estimation of market value. However, an exact formula or rule of thumb does not exist. Therefore, it is ultimately the job and responsibility of the appraiser to conclude on a reasonable market value of a subjet real estate property.