When I was in my early appraisal career, more than 20 years ago, I remember a friend who used to ask, “How do you come up with the appraised value? Roll dice?” The mystery of commercial appraisal valuation is common for most everyone outside the appraisal industry. However, the mystery is easily solved.
There are three standard, generally accepted approaches to determine market value for commercial properties. They are:
Cost Approach: This means exactly what it implies. For any given “subject” property, the appraiser calculates the cost to reproduce the existing improvements, accounting for all forms of depreciation. This approach is most often used for relatively new construction. The Cost Approach is not typically emphasized by buyers/sellers for older buildings due to the difficulty in precisely calculating the various forms of depreciation, resulting in lower reliability of the value indication.
Sales Comparison Approach: In this approach, the most recent, comparable sales are compared to the subject, with adjustments applied for relevant differences (such as location, age/condition, construction quality, land/building ratio, etc.). This approach draws heavily on the principle of substitution.
Income Capitalization Approach: This methodology involves analysis of the income and expense characteristics of a property. Projected or actual annual rental revenue is calculated, with vacancy and expenses deducted to produce a net operating income (NOI). The NOI is capitalized at an appropriate rate of return (i.e. the rate required by investors for that particular property type to reflect the associated overall risk of the investment) to indicate the value of the property. This approach is often relied upon heavily for income-producing properties such as retail, office and apartments.
After developing the approaches to value (which may not necessarily be all three in any given assignment), the appraiser places appropriate weight on each value indication based on relevance and the availability of reliable data, to reconcile the analysis into a final value conclusion.
There are no dice involved.
John Fisher CCRA, LEED AP
Managing Director, Appraisal Services
O’Connor & Associates