Which Real Estate Valuation Approach is Most Reliable?

San-Diego-Commercial-Real-Estate-AppraiserWhen appraising commercial real estate, there are three generally accepted approaches to value: the sales comparison approach, the income capitalization approach, and the cost approach. Each approach is used to help assist an appraiser to determine an opinion of value, and many times all three approaches are used to appraise a single property. However, there are instances where one approach may be considered more reliable or credible than the others. Here are instances when a particular approach is the most reliable valuation method.

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Ground Lease Appraisal in San Diego

Commercial-Real-Estate-AppraiserIRR San Diego has completed a commercial appraisal of a property subject to a ground lease located in the Mission Bay area of San Diego. The subject consists of two parcels totaling 2.99 acres. Though the property is improved for automotive use, our valuation was of the site only. This appraisal included an analysis of the income, both from a direct capitalization and discounted cash flow analysis standpoint. The purpose of this commercial valuation was for loan underwriting purposes for a lender

If you have any ground lease valuation questions or needs, please contact us today at 858-259-4900 or sandiego@irr.com.

Yield Capitalization – How to Appraise Commercial Real Estate

Yield-Capitalization-Real-Estate-AppraisalWhen appraising commercial real estate based on a property’s income potential, an appraiser uses capitalization to convert income into value. In fact, the definition of capitalization is simply the conversion of income into value.

We have previously discussed direct capitalization, which is the process of converting a single year’s expected income into value in one step, either by dividing net operating income by a capitalization rate (cap rate), or multiplying income by an appropriate factor. Direct capitalization is most commonly used for small commercial properties or properties which have stabilized, predictable income (such as apartment complexes).

Yield Capitalization – What is it?

The other capitalization method used to appraise commercial real estate is yield capitalization, which is defined as the process of converting future benefits into present value. In other words, future cash flows that a property generates are converted into a present value conclusion using an appropriate yield rate. The most commonly used method of using yield capitalization is discounted cash flow analysis, where each future year of income is discounted to present value using a discount rate. While capitalization rates are typically derived from market data (sales that reported a cap rate), discount rates are typically supported by published yield rate data or by interviews with market participants such as investors.

When Does an Appraiser Use Yield Capitalization?

Yield capitalization is often used to value complex commercial properties (such as office towers and shopping centers) or properties which will take several years to become stabilized (such as high vacancy properties, proposed projects, etc.). It is also used to by valuation professionals to estimate value over a given holding period. For example, if an investor plans to purchase a property, hold it for five years, and then sell it, then yield capitalization can be used to determine value based on the projected performance (future cash flows) during the five-year holding period.

What’s the Difference Between Direct and Yield Capitalization?

The main difference between direct and yield capitalization is time. Direct capitalization is based on only a single year’s income, while yield capitalization takes into account several years of cash flows. Depending on the property type, income characteristics, and the overall assignment, one or both methods of capitalization may be appropriate.

Summary

If you have any additional questions about yield capitalization, or if you are in need of a discounted cash flow analysis of commercial real estate, please contact us today.

Direct Capitalization: An Introduction to Cap Rates

858.259.4900-San-Diego-Commercial-Appraiser-direct-capitalizationIn the income capitalization approach to value, direct capitalization is a method used to convert a single year’s expected income into value. This method is done in one step, by dividing the net operating income estimate by an appropriate income rate.

Direct capitalization is generally used when the property is operating on a stabilized basis. For example, the property is leased at market rents and has a market occupancy rate. This method is also used when there is a sufficient supply of comparable sales to extract capitalization rates, and/or there are enough other methods for determining capitalization rates.

Direct capitalization is less useful when the property is not stabilized. Examples of a property not being stabilized include high vacancy and irregular income/expenses expected in the near future. Additionally, direct capitalization is also less useful when there is not a sufficient supply of comparable sale data.

The advantages of direct capitalization are that it is simple to use and easy to explain, it often expresses the way the market thinks, and it provides strong market value support when there is enough sale data. Disadvantages include the fact that it does not consider individual cash flows beyond one year and that there must be enough sufficient comparable data.

The most basic method of direct capitalization is applying an overall capitalization rate to relate value to the entire property income (i.e., net operating income). The formula for this is as follows: San-Diego-Commercial-Appraisal-Cap-Rate Overall capitalization rates can be estimated with various techniques, which depend on the quantity and quality of data available.  Examples of these techniques include:

  • Comparable sale data (cap rates from comparable sales)
  • Band of investment—mortgage and equity components
  • Band of investment—land and building components
  • Debt coverage analysis
  • Analysis of yield capitalization rates
  • Surveys (Broker, Investors, Owners, etc.)

If you have a stabilized income producing property in San Diego, then direct capitalization may be one of the methods to value your commercial real estate. If you have any questions about direct capitalization, or if you have any San Diego commercial real estate appraisal needs, please contact us today. You can also check out our YouTube Channel, which includes various topics on the commercial appraisal process.

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