How Real Estate Value Is Estimated: Price, Value, and Basic Valuation Methods

Price vs. Value vs. Cost (Three Different Ideas)

Price is what someone actually paid (or agreed to pay) in a specific transaction. It can be influenced by urgency, negotiation skill, special financing, or unusual terms.

Value is an estimate of what a typical buyer would likely pay under normal conditions. It is an opinion supported by evidence and assumptions.

Cost is what it would take to create or replace the property (or a similar one). Cost is about building/producing; value is about what the market will pay; price is the one observed outcome.

Quick interpretation checks

• A home sells for $30,000 above similar homes because the buyer needed to move in within 10 days. Is that price or value? (It’s price; value may be lower.)
• A brand-new custom build costs $650,000 to construct, but similar homes sell for $600,000. Which is higher: cost or value? (Cost can be higher than value.)
• Two identical condos sell for different amounts because one seller offered a large credit at closing. Does that change the condo’s value? (Not necessarily; it may change the effective price.)

Three Core Valuation Approaches (No Advanced Math)

Most basic valuations rely on one or more of these approaches:

• Sales Comparison Approach: value is inferred from recent sales of similar properties (“comps”).
• Cost Approach: value is estimated as land value plus what it would cost to build the improvements today, minus depreciation.
• Income Approach: value is tied to the income the property can produce, often summarized using NOI and a capitalization rate.

1) Sales Comparison Approach (Comps and Simple Adjustments)

The sales comparison approach asks: “What have similar properties sold for recently, and how does this property differ?” You select comparable sales and adjust them conceptually to reflect differences.

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Step-by-step process

1. Define the subject property in practical terms: location, size, condition, features, and any standout items (garage, view, renovations).
2. Select comps that are as similar as possible and as recent as possible. Prefer same neighborhood/market area and similar property type and size.
3. Check comp reliability: Was it an arm’s-length sale? Any unusual terms (seller financing, big credits, distress)?
4. Adjust for differences (conceptually): If a comp is superior to the subject on a feature, adjust the comp downward; if inferior, adjust upward. The goal is to make each comp “look like” the subject.
5. Reconcile: Give more weight to comps that are most similar and most recent, and form a value range and a point estimate.

Common adjustment categories (conceptual)

• Time/market conditions: if prices have been rising, older sales may need upward adjustment.
• Location: same street vs. busy road, school zone, view, proximity to amenities.
• Size and layout: gross living area, bedroom/bath count, functional layout.
• Condition/updates: renovated kitchen, roof age, overall maintenance.
• Extras: garage, pool, finished basement, lot size.

Worksheet-style example (small numbers, clear assumptions)

Subject: 3-bed/2-bath home, 1,500 sq ft, average condition, no pool, typical lot.

Assumptions for simple adjustments (for learning only):

• Extra 100 sq ft is worth about $5,000.
• A pool contributes about $10,000 in this neighborhood.
• “Updated kitchen” contributes about $7,000 versus average condition.

Adjustment logic: Adjust each comp to estimate what it would have sold for if it were the subject.

• Comp A is superior (100 sq ft larger and updated kitchen). Adjust it down: $250,000 − $5,000 − $7,000 = $238,000.
• Comp B is superior (has a pool). Adjust it down: $245,000 − $10,000 = $235,000.
• Comp C is inferior (100 sq ft smaller). Adjust it up: $260,000 + $5,000 = $265,000.

Reconcile: The adjusted indications are $235,000, $238,000, and $265,000. Comp C is farthest from the others; you would ask why (different street? better lot? bidding war?). If you decide Comp A and B are more similar/reliable, you might focus on a range around $235,000–$240,000.

Interpretation checks (not speed math)

• If a comp has a feature that the subject lacks (e.g., a pool), do you adjust the comp price up or down to match the subject? (Down.)
• If the most similar comp is older but the market has been rising, what direction might a time adjustment go? (Upward.)
• If adjusted comp prices spread widely, what should you do before averaging? (Investigate differences/quality of comps and weight the most reliable.)

2) Cost Approach (Land + Replacement Cost − Depreciation)

The cost approach asks: “What would it cost to buy the land and build a similar property today, then subtract for wear-and-tear and obsolescence?” This approach is often most useful for newer properties or special-use buildings where comps are limited.

Key pieces in simple terms

• Land value: what the site alone would sell for (as if vacant).
• Replacement cost (or reproduction cost): the cost to build a similar utility today. Replacement cost usually means “similar function,” not an exact replica.
• Depreciation: loss in value from age, condition, design issues, or external factors. In basic form, think: new cost minus what’s been ‘used up’.

Step-by-step process

1. Estimate land value using land sales or extraction logic (in practice). For this chapter, we’ll use a stated assumption.
2. Estimate replacement cost new of the improvements (structure and site improvements).
3. Estimate depreciation (physical wear, functional issues, external influences) in a simple lump sum or percentage.
4. Add land + (replacement cost − depreciation) to get an indicated value.

Worksheet-style example (small numbers, clear assumptions)

Subject: Small single-story building.

Assumptions:

• Land value (as if vacant): $80,000
• Replacement cost new of building: $220,000
• Depreciation (age/condition): $40,000

Compute the indicated value:

Value ≈ Land value + (Replacement cost new − Depreciation)  Value ≈ 80,000 + (220,000 − 40,000)  Value ≈ 80,000 + 180,000  Value ≈ $260,000

How to think about the depreciation number (conceptually): If the roof is near end-of-life, finishes are dated, and some systems are older, depreciation represents the “gap” between a brand-new version and the current condition.

Interpretation checks

• If construction costs rise sharply but the neighborhood sale prices don’t rise as much, what can happen to the relationship between cost and value? (Cost can exceed market value.)
• Why might the cost approach be less reliable for an older property? (Depreciation is harder to estimate; functional/external issues can be significant.)
• If land values in the area jump, which part of the cost approach is most directly affected? (Land value.)

3) Income Approach (NOI and Cap Rate Intuition)

The income approach asks: “What is this property worth based on the income it can produce?” It is commonly used for rentals and other income-producing properties.

Core terms (kept simple)

• Gross rent (or gross income): total rent collected if fully occupied.
• Vacancy/credit loss: an allowance for empty units and nonpayment.
• Operating expenses: ongoing costs to run the property (taxes, insurance, repairs, management, utilities paid by owner). This typically excludes loan payments and income taxes.
• NOI (Net Operating Income): income after operating expenses, before debt service.
• Cap rate: a market-derived rate that links NOI to value. Intuition: higher cap rate generally implies higher perceived risk or lower growth expectations, which results in lower value for the same NOI.

Step-by-step process

1. Estimate potential gross income (market rent × units).
2. Subtract vacancy/credit loss to get effective gross income.
3. Subtract operating expenses to get NOI.
4. Convert NOI to value using a cap rate: Value ≈ NOI ÷ Cap rate.

Worksheet-style example (small numbers, clear assumptions)

Subject: Duplex (2 units).

Assumptions:

• Market rent per unit: $1,200/month
• Vacancy allowance: 5%
• Annual operating expenses (taxes, insurance, repairs, management, etc.): $10,000/year
• Market cap rate for similar duplexes: 8% (0.08)

Step 1: Potential gross income (annual)

2 units × $1,200/month × 12 months = $28,800/year

Step 2: Effective gross income after vacancy

Vacancy (5%) = 0.05 × 28,800 = $1,440  Effective gross income = 28,800 − 1,440 = $27,360

Step 3: NOI

NOI = Effective gross income − Operating expenses  NOI = 27,360 − 10,000 = $17,360/year

Step 4: Value using cap rate

Value ≈ NOI ÷ Cap rate  Value ≈ 17,360 ÷ 0.08 ≈ $217,000

Cap rate intuition (interpretation focus)

• If two properties have the same NOI but one is riskier (unstable tenants, weaker location), it often trades at a higher cap rate, which implies a lower value.
• If the market becomes more confident (lower perceived risk), cap rates may compress (go down), which can push values up even if NOI is unchanged.

Interpretation checks

• Does NOI include mortgage payments? (No.)
• If NOI stays the same and the cap rate increases from 8% to 10%, what happens to value? (Value decreases.)
• Which matters more for value: high rent with very high expenses, or moderate rent with low expenses? (NOI is what matters; expenses can erase high rent.)

Choosing an Approach and Cross-Checking Results

In real-world practice, valuers often use more than one approach and compare the results for reasonableness.

• Sales comparison tends to be strongest when there are many recent, similar sales.
• Cost approach tends to be helpful for newer properties or when land/building costs are central to buyer thinking.
• Income approach is central when buyers focus on cash flow and returns.

Quick cross-check prompts

• If the income approach value is far higher than sales comparison, ask: are rent assumptions too optimistic, expenses too low, or cap rate too low?
• If the cost approach value is far higher than sales comparison, ask: are construction costs high relative to what buyers pay in this area, or is depreciation underestimated?
• If sales comparison is higher than cost, ask: is land scarce, are buyers paying premiums for location, or are replacement costs understated?