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The Three Valuation Methods Used By Commercial Real Estate Appraisers

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Buying commercial real estate for the first time is very stressful. Not only is it more expensive than residential real estate, but it is also much harder to determine if you are getting a good deal. 

If you have found a potential new building for your business and want to have it appraised, then you will need the services of a commercial real estate appraiser. 

The appraiser will use one of three valuation methods to determine how much the building you are considering is worth:

  1. cost valuation
  2. income capitalization
  3. sales comparison

Here is some information about each valuation method:

Valuation Method #1: Cost Valuation

The cost valuation method of appraising commercial properties uses comparable sales, much the same way as residential appraisals do. This method takes into consideration a property's:

  • location
  • size
  • amenities

Cost valuation subtracts for anything lowering a property's value, such as:

  • aged HVAC systems
  • aged roofing
  • outdated features or designs
  • structural issues
  • physical deterioration

Generally, cost valuation is utilized when a commercial real estate appraiser is valuing property that is not income-generating, such as a church or government building. These types of buildings typically have less value than retail or professional buildings. 

However, cost valuation requires both a stable commercial real estate market and an adequate number of comparable sales. Finding comps can be a problem, especially in small towns, markets without many recent sales, or during times of economic uncertainty.

Valuation Method #2: Income Capitalization

The income capitalization valuation method is focused on the income the property will generate. For this reason, income capitalization is utilized for income-producing properties, such as:

  • retail properties
  • office buildings
  • multi-family housing properties

There are two different ways a commercial real estate appraiser calculates a property's expected income:

  1. Gross Income Multipliers: dividing the property's sales price by its yearly rental income.
  2. Direct Capitalization: estimating the property's yearly gross income and subtracting expenses and expected losses due to depreciation

Income capitalization works the best for commercial properties with expenses and focuses on its expected rate of return.

Valuation Method #3: Sales Comparison

Also called the "market data method", sales comparison is exactly what the name implies - utilizing recent comparable sales to determine value. 

Several local, similar properties are selected and when averaged together they infer the value of the commercial real estate in question. The properties chosen don't have to be identical matches, but they need to be very similar and in the same market.

While this is the simplest valuation method, it cannot be utilized in areas with small commercial sales markets or those with very dissimilar commercial properties.

A Final Note

Finally, it is important to note that many commercial real estate appraisers choose to use multiple valuation methods. Since the appraisal's accuracy is vital, using multiple methods often gives you a more accurate valuation.