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.

Sales Comparison Approach

The sales comparison approach is most reliable when there are several similar properties available. This may seem a little obvious, but an active market is key when applying the sales comparison approach method because there must be sufficient sales data available to analyze. If an appraiser is valuing a property in a slow market or is appraising a unique property that normally does not change hands (like a religious facility or other special-purpose property), then caution must be used when applying this approach to ensure that the most similar properties are selected and that the sales share similar physical and locational characteristics.

This approach is also typically most relevant for owner-user properties. When an owner occupies a property, the emphasis on value is not necessarily on the income-producing potential of the subject. While an investor is interested in a return on investment, an owner-user may be more interested in the age and size of the building to fit their business’ needs. In this case, an appraiser would value the subject based on sales of other other-user properties that are similar in age, size, or other relevant factors.

Income Capitalization Approach

The income capitalization approach is considered most reliable when the probable buyer of the property would primarily base their purchase price on the income generating potential of the subject property and an anticipated rate of return. This approach is generally most applicable to multi-tenant properties such as shopping centers or going concern valuations such as hotels or car washes where the emphasis on value is more on the income the property can produce.

As with the sales comparison approach, there also must be sufficient market data regarding income (whether in the form of rent or income for going concern properties), expenses, and rates of return such as capitalization rates or yield rates. Unless there is enough information to analyze, an estimate of the property’s income generating potential would not be reliable.

Cost Approach

The cost approach to value is simply the estimated value of the land plus the depreciated cost of the improvements (building, site improvements, etc.). Therefore, the cost approach is most reliable when the appraiser can develop reliable estimates of land value and improvement costs. There must be sufficient data to estimate the value of the land (as land value is generally estimated via the sales comparison approach) as well as reliable sources to estimate replacement or reproduction cost.

The cost approach is also typically most reliable when the subject represents new, nearly new, or proposed construction. In these instances, the subjectivity of estimated accrued depreciation is reduced compared to older construction. Lastly, the cost approach is most reliable when appraising special-purpose or unique properties in which sales and rental data is limited. As we discussed in the other two approaches, if there is limited data to analyze, then any adjustments made to the data would be relatively subjective.

Summary

Each of the three approaches can be the most reliable based on a number of reasons described above. However, just because one approach is more reliable, it doesn’t mean that it should be the only approach used. An appraiser generally uses two or even all three approaches to value, with the analogy given that each approach or method of valuation is like a leg to a stool, and that the more legs that are added the more supportable the stool is. Similar to commercial real estate valuations, the more methods that can be applied (backed by sufficient data), the more supportable an opinion of value can be.

If you have any any questions regarding approaches to value, or if you have any other real estate valuation questions or needs, please contact IRR today at 858-259-4900 or sandiego@irr.com.

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