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Valuation Strategies in Commercial Real Estate Appraisals

Commercial real estate valuation is different from residential real estate valuation. 

The heightened value and added intricacies of commercial properties make the appraisal process much more complex. Due to the nuances of commercial real estate, a commercial real estate appraiser must consider several factors and conduct a more thorough property assessment to determine its value.

When it comes to formulating the value of a commercial property, there are three tried and tested methods which are normally used, they include the cost approach, the sales comparison approach, and the income capitalization approach.

Below, we detail the three approaches, explain the differences in the methods, and illustrate when each approach is commonly used.

What is Cost Approach Appraisal?

The cost approach values property by valuing the improvement to a property, subtracting depreciation, and adding the value of the land that it’s on. This method estimates the price of real property by determining what it would cost to rebuild the building if it was destroyed or to build an equivalent structure.

The cost approach typically yields the most accurate value for newer or renovated properties. Since there's less depreciation to estimate, it's easier to determine what it would cost to build the improvements new. The logic behind the method is that it is impossible to pay more for a property if building its replacement or a reproduction of the building would cost less.

There are three main components to the cost approach:

  • The Land (or Site) Value
  • The Building Construction Cost (replacement or reproduction)
  • The Real Estate Depreciation

The formula for the cost approach is:

Property Value = Land Value + (Building Construction Cost – Real Estate Depreciation)

The appraiser begins by determining the land value. The cost of the land is taken at its current market value. The appraiser will look at other recently sold plots of land in the same market or competing markets to determine the land value. Next, the appraiser will calculate building construction costs.

Two approaches when finding the construction cost of the building are:

  • Replacement Cost Approach. This approach calculates the cost to construct a similar property while adhering to current building codes and using existing construction materials.
  • Reproduction Cost Approach. This estimation looks at the current cost to construct an exact duplicate of the property, including the materials and standards in place when the building was initially built. The estimate is based on creating a replica of the building using the same materials, construction method, and design as when it was built. This approach is common for older buildings that exhibit unusual or unique construction.

The final piece of the cost approach is to calculate depreciation. The appraiser will consider three separate forms of depreciation a property can experience, which can potentially affect the value:

  • Physical Depreciation. Physical depreciation is the most common type of depreciation. It results from building aging and everyday wear and tear.
  • Functional Depreciation. This addresses any property issue with floor plan layout or other design issues. Since commercial properties are often unique to the business, it is an essential component. Any changes that could reduce the asset's value over time are calculated.
  • External Depreciation. This form of depreciation is the result of adverse economic trends. It can be caused by negative market trends or the geographic area the property is located.

What is a Sales Comparison Approach?

When using the sales comparison approach, also called the market approach, an appraiser compares the property to the sales prices of similar area properties. The appraiser will consider the market conditions and analyze other differences between the subject and the “comps” to reconcile an indicated value for the subject.

Adjustments are normally made to account for factors such as market conditions, location, and physical characteristics that differentiate the subject property from comparable properties. If the subject property lacks a given feature in a similar property, the price is adjusted downwards. Consequently, if the property has a valuable feature not found in the comparable property, the value is adjusted up accordingly.

Finding comparable for residential properties is typically straightforward. However, due to the unique characteristics of commercial properties, the sales comparison approach is more complicated and usually more research intensive. Common characteristics evaluated include location, lot size, building features, property age, condition, and functional utility.

What is the Income Capitalization Approach?

The income capitalization approach or income approach is a valuation method using the income a property generates to measure the value of the underlying real estate. Essentially, the more revenue a property generates, the higher its value.

Income capitalization can be applied to retail, commercial, and industrial properties. It is commonly used to value condominiums, office buildings, shopping centers, and warehouse facilities. The income approach considers all the income the property will generate. It values real estate using more than just rental income numbers. This appraisal approach consists of the capitalization rate and net operating income.

The formula for the Income Approach is:

Property Market Value = Net Operating Income / Capitalization Rate

The appraiser considers the net operating income of comparable properties to determine the income potential of the property. When evaluating commercial properties with this approach, the income-generating potential is carefully measured. If the property is an apartment complex, for example, rent rates, as well as vacancy rates, are considered.

The income capitalization approach is often a more detailed and lengthier valuation method than the cost and sales approaches due to the necessity of valuing the building and property and the income generation of the real estate.

Assessment Evaluation Can Help

As a business owner, you'll want to understand how to value your properties, but deciding which approach to use when appraising your business property is crucial. Understanding the pros and cons of each method is imperative, and knowing when to combine approaches is critical. Consider talking to Assessment Evaluation for your professional appraisal and tax appeal services.