Valuation Methods and Appraisals
Because each real estate property is different, determinations of value (outside of an actual sale) can be difficult. Appraisers and other professionals generally estimate property values utilizing three approaches: market data, cost, and income.
Property valuation is an art, not a science; there are so many factors involved in estimating value that appraisers always make clear that they are only giving an opinion of a property’s value. The underlying economic bases of value include: at what cost a substitute property can be obtained; estimating future income of the property; how change (nearby development and other trends) affects value; how competition will affect profits; whether contemplated improvements make a net contribution to value; whether the property’s use is in conformity with other activities in the area; supply and demand; and what the highest and best use of the land might be.
Because of these complexities, an appraiser will normally follow not a single path toward a value conclusion but will use three approaches:
- Market Data (comparable sales) – what are similarly situated properties worth?
- Cost – what would be the replacement value of the building?
- Income – what future cash flows is the property expected to generate?
Market data, or comparable sales, is similar to the comparison shopping done everyday when purchasing a new car or buying products in the local supermarket. It works best when very similar properties are bought and sold on a relatively frequent basis. No property is exactly the same, of course, so differences must be identified and compensating adjustments made when making the comparisons.
These difference are usually based on property characteristics; location, size of the land lot, square footage of the usable building space, and the type and quality of construction are perhaps the most important factors, although age, design, land terrain, and interior layout can also play a role. Other dissimilarities might include whether unusual financing terms are involved (e.g., low interest rate loans will encourage better prices), or if a property sale was not an “arm’s-length” sale or involved free post-sale rent or repairs. An estimate as to the value of the distinguishing features must be made, and the adjusted sales prices can then be correlated to give an indication of value to the subject property.
Cost analysis can start with a simple estimate using current local building costs; local builders can probably provide a generalized per-square-foot cost of new construction. A more rigorous approach would utilize one of the available published construction cost indexes, which break down costs by material types and region. A buyer seriously considering building a new structure may well retain a building contractor to make a complete building cost estimate.
The building’s current replacement cost then needs to be adjusted to reflect the actual state (and value) of the subject property. This involves reductions to reflect the property’s physical deterioration, functional obsolescence, and economic depreciation. The physical deterioration can involve some curable “deferred maintenance” that can be repaired, but it also involves the very real effects of age and the fact that some repairs are no longer economically justifiable. Functional obsolescence refers to the impact on income of changes in building technology and consumer tastes and preferences on the building’s value (an older building’s low ceilings may not be able to accommodate modern central air conditioning systems, for example). Economic depreciation refers to the external influences that could affect income compared to other locations; these could include pollution, noise, or zoning changes that permit industrial uses in a formerly residential neighborhood.
Income capitalization places a dollar valuation on the future stream of cash flows. This approach requires determining the amount, certainty, and length of time of future income from the property, and then applying an appropriate capitalization rate (or “cap rate”) to convert the future income into a present value. This approach is generally used by determining the net operating income of a property and then choosing a capitalization rate suited to the property’s type, location, age, and quality of tenants. This approach is discussed in more detail in our article on cap rates.
These three approaches will often provide three different values for a property, so an appraiser must reconcile the varying results. Depending on the property and the appraisal’s objective, one of the approaches may be more suitable than the others, so a simple averaging of the three results is usually not appropriate. An appraiser will need to meld the results of the three approaches in a sensible, reasoned way.
The three primary approaches to valuation each have positive and negative aspects. Comparable market data are always beneficial in a valuation analysis, and can indicate what cap rates investors are currently paying for comparable properties. On the other hand, recently sold properties are often not truly comparable to the property being evaluated, and might not adequately reflect the property’s actual projected income. The cost approach is more reliable when newer buildings are involved, and may also be the only choice where market data is scarce. In any case, an appraisal of value should be viewed as a complement, not a substitute, for sound underwriting or investment analysis.