3 methods of evaluation


Identifying fair market value


  Introduction

The basis for everything in the area of valuation, there are three internationally accepted methods for determining the market value of tangible or intangible property. These are respectively the cost method, the comparables method and the income method.

Depending on the nature of the property to be
the appraiser may choose to use one or more of these methods. You will find below some information that will help you understand and analyze your appraisal report when it is given to you.

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Teach you good manners​

It is relevant to mention that through these methods, in order to find the market value of an entity, there is a panoply of techniques related to each of them. To be clear, note here that we are talking about valuation methods but also about valuation techniques. Let's just say that what we need to remember is that if each valuation method allows us to evaluate the market value of an entity, the techniques themselves represent one of the multiple ways to execute the parent method.

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Keep in mind that the work of the certified appraiser is not to compete with the market, because its mandate is not to impose its ideas on the market, but to interpret it. This means that they will choose valuation methods that most closely reflect the buyer's behavior. Only in this way will chartered appraisers be able to determine market value.

For example, if the appraiser is evaluating a single-family residential property and its services, knowing full well that the potential buyer will be exposed to nearby residences and their selling prices, the appraiser will have to compare the supply of neighbouring properties to his own needs in order to get the most out of the market. Therefore, to determine the market value of the subject, the appraiser will tend to choose the comparison method and favour the adjusted price technique.

However, in other examples, in order to target the market value of a type of property such as a 12-unit multi-residential building or a business appraisal, since the potential buyer will want to buy for strictly monetary reasons, chartered appraisers will opt for a technique that immits this behavior, i.e. certain income techniques.


When these conditions are met, the appraiser will be able to estimate the most probable selling price. This is what we call in the jargon of chartered appraisers, the market value correlation exercise. Based on the results obtained by each method, the appraiser will comment on each one of them, in this case he will mention the reasons why he chose one method rather than another and will decide on the market value that he will retain for the purposes of the analysis.


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Method of comparison

   The mother of all methods

Why is it the mother of all methods? This is a statement that deserves at least some explanation. No matter which method is chosen, the fact remains that in each of them, the comparison method is always omnipresent in the process of determining the market value of a property.

If we take the income method for example and we want to extract the market discount rate (it is nothing more or less than an index of return expressed in %), we will look at the transactions of the properties recently sold on the market in order to extract the discount rate of the sales in question by looking at the sold price of each of them versus their net income in order to compare them and bring out the market discount rate, comparison! Another example: some costing methods ask you to compare the price of certain materials between them at different merchants in different sectors in order to extract the most accurate rate possible, again comparisons! Well, we don't need to extrapolate on the subject, but we could go on and on.

To explain what follows, let's take the case of a single-family home. The pure comparison method consists of analyzing the most recent transactions possible, located as close as possible to the subject within comparable markets in terms of economy, and which are as similar as possible. Each relevant element is then identified and measured, both in terms of the land and the building (living area, quality of materials, number of bathrooms, etc.), and then compared to the building under study in order to retain a representative market value.

In estimating value, the comparable approach and the techniques derived from it depend primarily on the type of property, both corporate and real estate. Generally speaking, this is often the best method available, but if there is a negative aspect to it, it is that it is more dependent on the comparables available. Indeed, it often happens that the market offers enough transactional volume to offer quality comparables. On the other hand, when transactions are scarce, the appraiser quickly becomes at the mercy of a moribund real estate market and it becomes difficult for him to evaluate comparable properties and their selling prices. The market does not offer the volume necessary to establish a solid value and at this point, the chartered appraiser will not be able to invent transactions and will have to limit himself with those available.


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Cost method

The unloved one

Some evaluators love it, while others swear it's an ordeal to use. One thing is certain, it leaves no one indifferent. Compared to the other two methods, evaluators who like to make value judgments with less tangible data are still a little disappointed. Indeed, the cost method, excluding land and depreciation, remains very mechanical and is often unchallenging for the appraiser, which makes it dull for some. For these same reasons, some people love it. In fact, it all depends on the personality of each accredited appraiser.

This method is also used to evaluate the costs of reconstruction requested by the syndicates of co-ownership who want to be in order in the eyes of the law and of their insurance companies.

Your municipality's tax department also uses a variation of the cost method because city property departments do mass appraisal and this method is particularly effective in these circumstances. Since a municipality cannot afford to use a more sophisticated system such as the banking system, which involves starting the entire process and description of the subject at each assessment, the cost technique used to produce the municipal assessment allows for a much quicker inventory of the buildings in its territory. Especially taking into account that the municipality will keep the property description of the properties forever, without having to redo it, except for the process of updating the roll or a house. This will make it possible to arrive at a probable sale price, much more quickly.

Speaking of sales price, when we seek to produce a cost that is as close as possible to the market value of a home, sometimes the cost method must be used to the market value of the land and the depreciated replacement cost of the building. The replacement cost then includes the buildings, structures and other items found on the land. However, certain elements will be treated as contributing value instead of depreciated value. The depreciation will come from a decrease in value caused by age, physical, functional or socio-economic impacts.

Finally, the appraiser will determine the value of the land using the comparison method and finally add the contributory value attributable to the exterior improvements. This method is used in virtually every appraisal report with a few exceptions.

It is also worth mentioning that it is sometimes preferable to use the cost method to value certain types of businesses. Sometimes it is to obtain a liquidation selling price, but not necessarily all the time. It is also sometimes fair to use this method for a business that requires a large inventory and a lot of fixed assets to operate, in order to find the most likely selling price of a property.

The cost method makes sense when it is necessary to devaluate a building without a comparable market. It acts in this case a little like a spare tire. It is also used for works with Atypical vocation to which the comparables are and will always be non-existent (ex: Olympic Stadium of Montreal, The Effel Tower)

The negative aspect of this method is that it is said to be an "indirect method", because it does not represent the behavior of the buyer. In fact, we can easily imagine a couple wanting to buy a house, walking around a neighborhood and hearing one of the two accomplices mention, thinking aloud: "Look at this one, it's practically identical to the one we saw on the previous street and has almost the same services. They are asking $20,000 more for it but it has an inground pool and the listing indicates that they have redone the bathrooms! This is actually replicable buyer behavior using the comparison method. It is also easy to think that the investor will be thinking about the return he can get from the market by paying the price indicated in the income method of the valuation he ordered for the business he is interested in. However, none of this exists in the cost method. Imagine someone in the process of buying a car exclaiming to the salesperson, "I want that one! This is the model that really inspires me, frankly I just compared your selling price with the price of metal per pound and wow! Quite an economy. I'm buying! You don't think that sounds fake, do you?

At Atypique, to obtain the reconstruction costs of Quebec, we use the CCR manual specialized for this purpose. It is also recommended by the Ordre des évaluateurs agréés du Québec for its reliability.


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Income method

The method of entrepreneurs and investors


The income approach estimates the market value of a property based on the net income it can generate and the returns required by the market for such an investment.

Let's just say that according to the standards, the basic recipe is simple. All income must be thoroughly analyzed and normalized in order to obtain a net income, then take the net income and apply it to the retained income technique. Even though the appraiser is analyzing current and past returns, he will always keep in mind that the value of a property under the income approach is completely relative to future income and not to past income. If the appraiser has serious reason to believe that future income will be impaired compared to historical income, he will make the appropriate adjustments.


We will not deal with normalization methods here, but be aware that this is a very important part of the final net income calculation. It is a difficult but necessary exercise. The appraiser will need to make adjustments for normalization of rent, salary, and any expense item that does not accurately represent what a normal expense should be, among other things.


The static income technique

This technique requires the comparison of similar properties in the market in order to extract the return that the market is willing to pay for this type of investment. It is this return that specialists call the discount rate. In a wrong way, some people call this ratio the capitalization rate or ''cap rate''. ​

Without going into detail, it is relevant to give you a small demonstration of the calculation of the discount rate. Let's take the example of a property generating $60,000 in net income. If we have an indication from the market that the discount rate recovered is 6%, we are able to know the most likely selling price. 60,000 / 0.06 = a value of $1,000,000. However, if we have a comparable that sold for $1,000,000 and generates $60,000 in net income, we can also conclude that the current market is willing to pay a return at the 6% discount rate, e.g. $60,000 / $1,000,000 = 6%. Also note that the NIM (net income multiplier) is exactly the inverse of the discount rate. This is correct, but expressed differently. 1 000 000$ / 60 000$ = 16,66. The property sold for a NIM of 16.66 times the income.

This method is called static because it does not take into account future renovations or inflation. It assumes that you will never sell and that your chosen rate of return will remain the same forever. Despite its imperfections, this is by far the most widely used method on the market. Be aware that even if your banker is aware of the imperfections of this method and that you make them fallacious, he will probably not change his mind regarding the veracity of the result because it is ''THE'' most recognized method.

While it is critically important to get discount rates directly from the market, there are national firms that will corroborate the pan-Canadian rates. If the appraiser is unable to gather sufficient data to establish quality rates, he or she can fall back on the rates of specialized firms. Coupled with a combination of other methods such as cost and comparables, the appraiser will still be able to establish the market value of the subject.

The dynamic income technique

The queen of income techniques, many call it the "Discount Cashflow" method. It is not really easy to establish and the one who applies it can easily get lost and obtain very varied results. However, if it is well executed, it remains the best and the one that will take into account the most real factors potentially found in the market. Large investors such as institutions or managers of large portfolios, such as those managed by institutional pension funds, swear by this discounting technique.

This technique makes it possible to establish a strategy by year, to determine a game plan, to take into account all the aspects which can vary annually such as the whole of the incomes but also of the expenditure. This technique also allows the calculation of a so-called "personal" return to the investor by deciding in time the date of resale of the property and include it in the calculation.

Let's take the example of an institutional investor who has a chartered appraiser working for him who wants to strategize about a shopping center he wants to buy.

For example, the investor will choose the inflation rate that he or she expects to be applied year after year on an individual basis, with the added bonus of being able to adjust it if he or she anticipates a change in the market. He will be able to forecast the variation of the cost of expenses and energy if he wishes. He will take the leases of each of the tenants present today in order to foresee the end of them. He will also be able to predict their chances of renewal, the rent increases in case of renewal or the amount lost in vacancy in case of departure. It can then predict certain space development costs for those who do not wish to renew, by multiplying it by the established % probability of departure. Oufff!

This is only an example, as it is only for the purpose of understanding, but hopefully it has been clear enough for you to understand. Subsequently, the owner may decide for example that it is better to sell the building after 8 years of ownership, because it is better to sell before the lease of his most lucrative tenant ends, or on the contrary, to wait 10 years so that the latter has renewed upwards. Therefore, it makes the value explode and makes the investment risk disappear in part. After establishing the whole strategy, the cash flows of each of the years of ownership as well as those of the reversionary year (the year of resale of the entity), will all be discounted at the selected discount rate.

From there, the buyer will be able to work his strategy not only with the market discount rate but also with his own personal reference discount rate as a decision tool by calculating the IRR of the investment at a given purchase price and then adding the desired profit expressed in %. (The IRR is the internal rate of return that brings the NPV of a project to zero)

The BAIIA

When it comes to business valuation, the standard is often to analyze a few ratios to get a better picture of the business. Without wanting to analyze them all, it is difficult to talk about the income method without mentioning the acronym EBITDA. It is neither more nor less than a static method presented in the form of a ratio, whose return is ideally drawn from the market. This form of static income technique is a suitable form for business valuation and is therefore the most widely used. The fact that it is also the ratio most often presented to bankers is a significant advantage for investors. Even if it would be a mistake to unilaterally claim that this is the best known formula, because it is also possible to apply a dynamic method to the valuation of a company, the fact remains that it is the best known.

EBITDA is the ratio of net income before depreciation, interest, taxes and amortization. Simply take, as the name implies, net income and add depreciation, interest and taxes and take the result and multiply it by the industry multiplier. 

Basically, the multiple of the EBITDA, by sector of activity, will often be situated between 3 and 5. It is the result of this equation that will then serve as the market value of a property. e.g.: a business with an EBITDA of $65,000 whose sector grants a multiple of 3.5, will have a deemed market value of $227,500. Just like the potential difficulty in finding market discount rates, one of the additional difficulties here for the appraiser is to have access to sufficient business data in order to compile, for example, a reliable multiple bank. Fortunately, there are also specialized firms in this area that specialize in correlating this type of multiple for all North American sectors.

Why EBITDA? Because it is much easier to compare the value of a business if you exclude considerations related to the financing structure (interest), the tax aspect (taxes) and expenses excluded from the cash flow such as depreciation. Here is the explanation! If you decided to sell your home, would the amount of your remaining mortgage balance and the amount of interest you pay each month have any impact on your selling price? No? Then why would it be any different if you were selling a business?

Broadly speaking, EBITDA is a representation of the cash flow generated by the normal operations of the business. Beware that by excluding mortgage costs in this way, as we do with EBITDA, EBITDA does not take into account the market value of a real estate investment, in which case the building included in the sale will have to be added to the selling price retained by EBITDA, but that's a whole other story.

  

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