Estate Valuations
Settling an estate usually requires an appraisal to establish Fair Market Value for the residential or commercial property involved. Often, the date of death differs from the date the appraisal is requested. Having a professional appraisal gives the executor solid facts and figures to work with in meeting IRS and state agency requirements.
Commercial Real Estate Valuation Approaches
These are the valuation approaches commonly used for commercial real estate:
Cost Approach
The cost approach values the property as equal to the land price plus the cost of constructing the building from scratch. For example, if a tract of land costs $40,000 and the price of constructing a six-unit apartment house is $600,000, the cost approach yields a value of $640,000.
The cost approach assumes that the cost of a property is based on its highest and best use. For example, if you have a tract of land in the midst of oil country, away from urban areas, you should assume a value based on using the property to generate oil income rather than building a rental property on the site. The cost approach is also affected by zoning laws that might impact the possible uses of the property.
The cost approach is used by lenders for new construction to release funds with the completion of each phase. Its main advantage is that it provides a current value based on unique conditions. However, this approach doesn’t account for the income the property will produce or the price of comparable properties.
Income Approach
In the income approach, value is linked to rental income via the property’s cap rate. The equation for the property value is:
Current Value = Net Operating Income / Cap Rate
The cap rate is extrapolated from market sales of comparable properties in the same neighborhood. The cap rate can be adjusted to account for unique features of the property, such as high-quality tenants or a less attractive façade. The final cap rate should be within half a percentage point of the local average for comparable properties.
To take an example, rental property with an annual NOI of $700,000 and a cap rate of 8% would be worth $8.75 million ($700,000 / 8%).
The advantage of the income approach is that it accommodates recent sale activity of comparable properties and can be adjusted for unique factors. Its disadvantage is that it doesn’t account for vacancy and collection loss, which leads to an overstated NOI and value. It also doesn’t account for necessary extensive repairs that will cut into future NOI.
Sales Comparison Approach
The sales comparison approach to valuation, also called the market approach, relies on the prices realized from recently sold comparable local properties as well as the asking prices on currently listed properties. The sales comparison approach is often used to appraise residential properties, such as single-family homes and multiunit structures.
The approach is to classify the property’s characteristics, such as number of baths and bedrooms, lot size and square footage, and then find recent local sales or current listings of similar properties. Sales should be as recent as possible, especially when the real estate market is in a dynamic phase.
The advantage of this method is that it relies on recent, relevant data to provide a good estimate of value. The disadvantage is that many properties have one or more unique features that affect the relevancy of comparable properties. Another disadvantage is that comparable sales might be too old to be an accurate indicator of current value, and/or current listings do not correctly reflect current values. Finally, the sales comparison approach doesn’t account for vacancy and collection loss, or unusual costs for repairs and other expenses. A trained real estate professional should be able to accommodate the differences among comparables to accurately tweak the property’s value.
Gross Rent Multiplier Approach
The GRM approach is similar in concept to the income approach. It differs in that the cap rate used is based on gross rent rather than NOI. The GRM is a number greater than 1, whereas the income approach’s cap rate is a percentage less than 1. In addition, this approach relies on gross rents rather than NOI, which means it doesn’t account for expenses, repairs or vacancy and collection loss.
The value calculation for the GRM approach is:
Property Value = Annual Gross Rents x Gross Rent Multiplier
For this to produce an accurate value, you need to know the GRM of comparable properties. This kind of information is often available from local commercial real estate agents and appraisers. As an example, to value a property that has annual gross rents of $90,000 and a GRM of 8, the property value would be ($90,000 * 8), or $720,000.
The advantage of this approach is its simplicity, and it works well if an accurate estimate of GRM can be secured. The disadvantages include the absence of expenses and vacancy and collection loss, and any difficulties identifying comparable properties and their GRMs. Like all of these valuation methods, the GRM approach is most useful when combined with other methods.
Other Approaches
Researchers have expressed interest in using the Capital Asset Pricing Model (CAPM) to value real estate. The CAPM method assigns a variable called “beta” that represents the relationship between risk-adjusted returns from a given asset and those of a market. For real estate, the return on an income-producing rental property can be used to estimate its value by choosing a beta that relates the property to, say, the return on publicly traded real estate investment trusts. The complexity of CAPM and the lack of precise betas means that this approach is of secondary importance pending further research.
A quick-and-dirty method used to value an apartment building is value per door. For example, a comparable building with 10 apartments priced at $2 million would have a value per door of $200,000. If you want to value a comparable property with 14 apartments, you might multiply 14 by $200,000, giving a value of $2.8 million. This only makes sense if the apartments are roughly equivalent. It doesn’t accommodate differences in apartment size and quality, vacancy and collection costs, or unusual maintenance/repair costs.
