Commercial Real Estate: The 3 Approaches to Value
In real estate appraisals, appraisers are most frequently asked to develop an independent and unbiased opinion of market value for a subject property.
Market value is determined by an appraiser who analyzes three types of market data: comparable sales, cost to replace (or reproduce), and income. The process of analyzing data from these sources is commonly referred to as “The Three Approaches To Value”.
Sales Comparison
“Sales Comparison is King.” – Numerous Appraisal Institute Instructors.
Sales Comparison is the approach to value that the public is probably most familiar with. In this approach, real estate appraisers research and analyze sales of similar properties (“comparables” or “comps”) in order to compare them to a subject property.
Sales comparison is usually the most insightful valuation method when numerous timely sales of similar properties are available to study.
To the greatest extent possible, appraisers strive to find comparables that buyers would consider to be acceptable substitutes for the subject property.
When I select comps, I always ask myself the question: “If the subject property was not on the market, what would the most probable buyer purchase instead?”
The goal is to find the most timely sales of properties that an appraiser feels would compete with the subject property in the open market.
After comparables are selected, an appraiser develops his or her opinion of value by considering factors that buyers and sellers consider to be important.
In the case of a single family home, bedrooms, bathrooms, land area, ocean views, and age/quality of construction are among the factors that would typically be considered.
In most cases, mathematical adjustments are made to each comparable sale in order to allow for fair comparisons. If a comparable has a superior trait, such as an extra bedroom, it is adjusted downward to match the subject.
If a comparable has an inferior trait, like a one car garage (instead of two at the subject), it may be adjusted upward to equate it to the subject property.
Cost Approach
Generally speaking, the cost approach is based on the idea that a rational real estate buyer would not usually pay meaningfully more for a property than it would cost to build new. The cost approach is most useful in valuing new improvements.
In addition, it is often the best (and sometimes the only) method for valuing properties that are rarely sold and/or generate little or no income (such as schools, churches, parks, or military properties).
The cost approach involves three basic steps:
1. Estimating the cost to reproduce (or replace) the existing improvements.
2. Deducting any depreciation that is present. (The most common form of depreciation is physical deterioration from age, but changing market tastes and external considerations can reveal types of depreciation known as “functional obsolescence” and “external obsolescence“, both of which I can discuss in a later article.)
3. Adding the value of the depreciated improvements to the value of the land underneath the property. (The land is valued separately using the sales comparison approach.)
After land value is added to the depreciated value of improvements, the total represents the value of the property via the cost approach.
Those interested in an in depth refutation of this concept are encouraged to obtain a copy of Nelson Bowes’ new book In Defense of the Cost Approach, published by the Appraisal Institute.
Income Capitalization Approach
The income approach is often summarized as “the present value of future benefits“. Properties that generate positive cash flow can be appraised using a “present value” or “time value of money” concept.
The income approach estimates the present value of (a) future income generated by a property and (b) its eventual resale value.
The term “capitalization” refers to the mechanism by which future income can be converted into a present value. There are two types of capitalization: Direct and Yield.
Direct Capitalization considers one year of income and converts it to a property value. The direct capitalization technique is often referred to as “Direct Cap” or using a “Cap Rate“.
Yield Capitalization differs from Direct Capitalization in one fundamental way: It considers multiple years of income and the eventual resale of the property.
The multiple years of income are converted to a present value using a “discount rate”. The application of this process is sometimes called a “Discounted Cash Flow” or “DCF“.
Yield Capitalization considers multiple variables and can become very complex. It is most appropriate for properties that are forecast to have uneven future cash flows (perhaps a large tenant is moving out in 3 years).
Real Estate Matrix is one of the Southeast’s premier commercial valuation firms and has participated in the valuation of billions of dollars in real property assets.
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