Commercial real estate appraisers use three main approaches to help derive their estimates: the cost method, sales comparison method and income capitalization method. Individually, each one of these techniques has its limitations, however, when paired with other methods these approaches help produce accurate appraisals.
The Cost Method
When using the cost method, appraisers assume that the value of a property is equal to the replacement cost of the structures on the property (minus depreciation) plus the market value of the land itself. This method requires an excellent knowledge of material costs and construction. While the cost method can offer some idea of a property’s value, it does not adequately capture many of the nuances of commercial real estate. For example, a hotel built in an inaccessible location may be worth far less than the cost of replacing the building since potential buyers would likely view it as a poor investment. While it is the least commonly used approach, the cost method offers appraisers a tool that can be helpful for assessing certain aspects of a property.
The Sales Comparison Method
When using the sales comparison method, appraisers seek out recently sold properties with similar characteristics in the same region as the property being appraised, then compare the properties; deducting and increasing value for comparative deficiencies or advantages. The more comparable sales that can be found, the stronger the final analysis. This method is effective for assessing a wide variety of real estate, so long as there are a sufficient number of comparable properties available to indicate true trends in the market. If the market is weak and there are few comparables available, the utility of this method is limited. However, when used in conjunction with other approaches the sales comparison method can be a helpful tool for deriving the value of a property.
The Income Capitalization Method
The income capitalization method uses a series of calculations to convert the potential income of a property into an estimate of its value. It is typically used for appraising commercial buildings such as offices and shopping centres, or properties with natural resources such as timber that can be harvested for income. The goal of this method is to estimate the present value of anticipated future benefits. In the case of commercial real estate, ‘value’ may be defined as the present worth of all future benefits to be extracted from a property. The main problem with this method is that appraisers cannot always guarantee the future value of goods and services since prices fluctuate over time. Nevertheless, this the income capitalization method provides many insights when assessing the value of commercial real estate, especially when paired with other methods.