Gaps of dozens of percent between the valuation approaches – comparative, income, and cost – may serve as a warning sign of a real estate bubble. In this blog, we will examine whether overvaluation according to the comparative approach indicates an inflated price and what can be learned from data in Israel and around the world since 2010.
This blog was compiled based on research we conducted - during the writing of the book Real Estate Bubble.
What happens when three moles disagree?
When a real estate appraiser is required to determine the value of a property, he can use three main approaches:
- The comparison approach – is based on prices of similar transactions.
- Income approach (discounting) – value is based on future rental flows.
- Cost approach – valuation based on reconstruction cost + land value.
Ostensibly, the three methods are supposed to converge to a similar value. But when the gap between them is abnormal – for example, the comparison approach yields a value 30% higher than the income approach – there is reason to suspect that this is an inflated market, and perhaps even a real bubble.
Are gaps between approaches an indicator of a bubble?
The answer: Absolutely yes – especially when valuation gaps widen without fundamental justification. In real estate bubble situations, the comparison approach is based on market transactions that are inflated by themselves. In contrast:
- The income approach remains true to the facts: rents do not jump in line with prices.
- The cost approach reveals the gap between the market price and the real cost of construction.
When the differences between the approaches are around 20%–40% or even more – this is a warning sign. The “market” value loses touch with the real economic value.
