Approaches to Value

What are the primary approaches when it comes to valuing commercial real estate?

Income Capitalization Approach

The Income Capitalization Approach is based on the principle of anticipation, meaning that properties are purchased for their income producing potential.  The two key steps in the Direct Capitalization are: 1) estimating the net operating income (NOI) and 2) selecting an appropriate capitalization rate.  When is the Income Approach given primary weight in the value conclusion?  When the most probable buyer of the subject property is an investor.   

Sales Comparison Approach

The Sales Comparison Approach is based on the principle of substitution, the value of the property is estimated by comparing it with similar and recently sold properties in the area.  Which will answer the question of what is the cost of buying an equally desirable property?  When is the Sales Approach given primary weight in the value conclusion?  When the most probable buyer of the subject property is an owner-user. 

Cost Approach

The Cost Approach is based on the principle of substitution, using the cost to construct a similar property as a reasonable alternative.  There are two components to this approach: 1) estimating value of the land and 2) estimating the costs to replace the improvements including direct costs, indirect costs, and entrepreneurial incentive.  Also, accounting for any accrued depreciation if warranted.  The Cost Approach is not used as commonly as the other two approaches given its limited applicability to many properties.  What are some instances where a Cost Approach could be relevant?  When dealing with a highly unique property, brand new construction, or proposed development.

Why is it important to understand the different approaches to value?  If your deal is getting bank financing and it gets to the appraisal stage, understanding how the appraiser will value the property can help manage expectations and mitigate some uncertainty.  Bonus tip: For most commercial real estate, banks require both the Income and Sales Approaches to be developed.  Then a reconciliation of value conclusions is performed by the appraiser which involves the weighing of the valuation techniques used and the reliability/applicability of each approach.