The cost approach valuation method

The value of a residential property is determined largely by its condition, but the value of a commercial property is determined by several other factors such as location, its potential to generate a rental income, floor plan and amenities. If your investment property is a new building, valuation might be simpler as it generally involves the construction cost and the market value of the land. In case of an existing property, however, appraisal becomes more complicated. Construction costs and market land value are factored in, but reduced by physical deterioration, structural and functional obsolescence, or by any external factors from the surrounding area such as extreme traffic, pollution, or anything else that would affect the operating income of the property. This appraisal method also factors in the useful economic life of the building, and the time that elapsed since the property was placed into service. Generally, it is difficult to use this method on anything other than a new structure.

Sales comparison approach

This method uses comparable sales data from similar properties that have been sold recently, and are similar in age, location, and overall property quality. So, data such as differences in sale date, geographic location, building age, square footage, and proximity to other landmarks are used to calculate an appropriate value. This approach works well when you have had a lot of transaction activity in your market within the last 12 months. But the less transaction activities you have in your market, the less useful this method is.

The income approach

If the cost approach and the sales comparison approach aren’t sufficient to come up with a valuation, a third method that is used in commercial property valuation is the income approach valuation method. Within the income method there are three main sub-methods. The first is the gross rent multiplier approach. This involves dividing sales prices of comparable commercial real estates by the gross rent that those properties are going to generate on an annual basis. This is going to give you a number that you can apply to the gross rents of your specific commercial properties. Often this isn’t all that helpful since most properties are going to have different expense ratios.

The second income approach method that is used is the direct capitalisation approach. In this method, instead of taking the gross operating income, you are taking the net operating income of the property into account. This is just applying a market-appropriate cap rate to a net operating income value, and taking that net operating income and dividing that by the market cap rate. The way valuers will come up with a market cap rate is they take comparable sale data, calculate what the cap rate was on those sales, and then apply that data directly to the subject commercial property. So if several inferior properties sold for a 6 per cent cap rate and the subject property that they are analysing is in a better location and slightly newer, they may apply a lower yield to the subject property.

The third income approach method is the discounted cash flow method. This includes forecasting net cash flows over a significant period of time – usually somewhere around ten years – assessing what the assumption will be for the sale price of the real estate at the end of the hold period. This is followed by taking the net cash flows, revenue, expenses, capital expenses, and projected sales proceeds when you assume to seal the deal, and then applying a discount rate to discount those cash flows to produce a valuation for the property.