Deciding the Best Approach for Commercial Real Estate Valuation

When valuing commercial property, there are three primary approaches typically used by appraisers:

  1. Direct Comparison

  2. Cost

  3. 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 weakness but one or more may have greater significance in a particular assignment.


The Direct Comparison Approach


Just as the name implies, the Direct Comparison Approach (DCA) compares the property being appraised, or the subject property, with other similar properties, or comparables, that have recently sold. The DCA can be used to value improved or vacant properties of all classes as long as sufficient market sales data is available. This approach is thought to best mimic the actions of buyers and sellers in the real marketplace.

The DCA focuses on the similarities and differences between the subject and the comparables. The elements of comparison typically include:

  • Real property rights conveyed

  • Financing terms (cash equivalency)

  • Conditions of sale (motivation)

  • Expenditures made immediately after purchase

  • Market conditions

  • Location

  • Physical characteristics (size, access, construction quality, condition, etc.)

  • Economic characteristics (expense ratios, tenant mix, lease provisions, etc.)

  • Use, zoning and land use controls

Appraisers apply dollar or percentage adjustments to the sale price of each comparable property as it relates to the subject property. Once the adjustment process is complete, the sales prices of the most equivalent sales comparables will indicate a value range for the subject property.


Advantages:

  • Suitable for most property classes

  • Easily understood and explainable

  • Mimics the actions of real buyers and sellers

Disadvantages:

  • Not suited to special use properties

  • Lack of comparable sales data

  • Difficulty in quantifying adjustments

  • Sales prices are historic

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.


The land value is estimated using the Direct Comparison Approach as part of the procedure. 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

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.


Advantages:

  • 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

Disadvantages:

  • 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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