Commercial Real Estate Valuation - Best Approach to Use? Part 2 of 3 - The Cost Approach
When valuing commercial property, there are three primary approaches typically used by appraisers:
Direct Comparison
Cost
Income
To develop a well-supported opinion of value, an appraiser may use one or more of these approaches; which approach is applied will depend on the type of property being valued, the intended use of the appraisal, and the quality of the data available. Each approach has its strengths and weaknesses, but one or more may have greater significance in a particular assignment.
The Cost Approach
The Cost Approach is based on the Principle of Substitution, which states that a knowledgeable buyer will not pay more for a property than it would cost to buy a similar site and construct equally desirable and useful improvements without undue delay. This approach assumes market participants equate value to cost.
Within the Cost Approach, appraisers arrive at a subject property’s value by adding the value of a vacant site to the current cost of constructing a reproduction or replacement of the improvements and then subtracting the amount of depreciation in the improvements from all sources. This approach is best suited to new or nearly new improvements or special-use properties that do not frequently transact in the marketplace. This is the only appraisal approach that does not rely on market activity.
Current construction costs are obtained from cost estimators, cost manuals, builders, and contractors, while depreciation is measured through market research. Entrepreneurial incentives may also be included.
Advantages:
Suited to unique or special use properties
Suited new or almost new developments
Not based on similar sales but strictly on the cost to develop
Disadvantages:
Loses reliability in older properties (depreciation is hard to estimate)
Not always possible to reliably estimate the site component due to a lack of vacant land sales
Requires assumptions in estimating construction costs and depreciation
Which valuation approach is best for commercial real estate?
The type of commercial property being appraised will dictate the approaches utilized; in most cases, two, if not all three approaches are applied to corroborate the value estimate produced by any one approach. The final step in any appraisal is reconciling the values generated by the various approaches into a single and final value estimate based on appropriateness, accuracy and quality of data. Ultimately, for any commercial property that produces income, the Income Approach is generally given the greatest weight.
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Malahat Valuation Group specializes in business valuation and real estate appraisals to owners of privately-owned companies and their professional advisors.
When owners need to leverage, sell or reorganize their assets, we answer the age-old question "What is it worth?".
We provide our clients and their advisors peace of mind by preparing professional valuations that stand up to scrutiny from lenders, the Courts, and Canada Revenue Agency.
Malahat Valuation Group Inc.
(250) 929-2929
