Commercial Real Estate Appraisal Methods

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Three real estate appraisal methods include the sales comparison, cost approach and the income approach. While an appraiser might use one or more of these methods when appraising commercial real estate, as a check and balance, the income approach is designed for commercial real estate.

Commercial Versus Business

Commercial real estate is income-producing property, such apartment buildings, office spaces, shopping centers or theaters. A business for sale, such as a landscaping service or real estate business, is not necessarily within a commercial real estate agent’s realm of expertise, as business resale is its own specialty. Commercial real estate focuses on real property that produces income.

Appraisal Methods

The sales comparison approach, commonly used when appraising residential properties, involves using recent sale price figures from comparable properties in the area to determine an estimated value. The cost approach is suited for unusual properties, where there are no available comparables. It involves determining the value of the land and replacement cost of the improvements, minus depreciation. Depreciation is the loss of value due to a variety of reasons, normally classified as physical deterioration, functional obsolescence or external obsolescence. The sales approach bases value on the recent sale prices of comparables, while the cost approach bases value on comparable land values and replacement costs.

Income Method

The income method bases value on potential future income. The process involves applying a capitalization rate to an estimate of the property’s annual net operating income. The annual net operating income is the projected annual gross income, minus an allowance for losses and operating expenses. Mortgage payments and interest are not operating expenses when making calculations within the income appraisal method, as they are considered debt service. To recall the process involved in the income appraisal method, the authors of "Modern Real Estate Practice" suggest remembering the acronym GIVEN, which stands for Gross Income (minus) Vacancy (and rent losses), (minus operating) Expenses (equals) Net (operating income).

Capitalization Rate

The capitalization rate is the rate of the investor’s return on her initial investment. An investor looking for commercial property is typically more concerned with the rate of return rather than the sticker price. To understand cap rates, consider a commercial property that generates $30,000 income annually. If it sells for $300,000, its cap rate is 10 percent. This means it will take the investor 10 years to recoup her initial investment. If the cap rate is 12 percent, it takes the investor longer to recoup her investment, while a cap rate of 8 percent is a quicker return than the 10 percent.