Commercial Real Estate Valuation - Best Approach to Use? Part 3 of 3 - Income Approach
Part one of a three-part series to help you understand which appraisal approach is best when valuing commercial property; there are three primary approaches typically used by appraisers:
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 Income Approach
The Income Approach is often preferred for income-producing properties as it most closely reflects the investment behaviour of knowledgeable buyers. This approach analyzes a property’s ability to generate financial returns as an investment. Any property that generates income would be appraised using this approach.
This approach estimates a property’s operating cash flow, and the result is utilized in a direct capitalization technique or a discounted cash flow analysis. Direct capitalization applies an overall market-derived capitalization rate to one year’s stabilized net income, while yield capitalization utilizes several years of stabilized cash flows combined with reversion value to establish value. Simpler and smaller investment properties will typically be valued using direct capitalization, while large complex properties such as malls or large rental apartments are typically appraised utilizing yield capitalization.
Most relevant to investors because it considers cashflow
Stabilizes the income and expenses to identify upside potential
Direct capitalization is a simple method that is easily understood
Requires detailed and often confidential information on comparable transactions, which can be difficult to collect
Small variations in any assumption can have a considerable impact on the value estimate
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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