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How to Value Real Estate

There are three common methods used to value real estate:[5] the cost approach, the sales comparison approach, and the income capitalization approach.[6] Regardless of whether the property is to be leased or purchased, the actual occupancy cost (i.e., monthly payment) directly correlates to the value of the property. In a purchase scenario, the correlation is quite clear. If the value of the property is $100,000, then the seller will be compensated $100,000. But in a lease scenario, the calculation of value is slightly more involved. For a lease, the monthly or annual rent equals some percentage of the total valuation. If, for example, the value of the leased property is $100,000, then the rental amount will generally be approximately 8 percent to 12 percent annually, or $8,000 to $12,000. Several examples of these scenarios follow to further illustrate the point. However, it is important to remember that, especially during times of depressed economic markets that see little or no sales of existing properties or new building activity, both the cost and sales methodologies will have marginal utility. We briefly describe each in the following:

  • Cost approach: The cost approach is most often used when you want to buy property that has an existing building on it. Estimating the current cost to construct a replacement for the existing structure and adding the estimated land value plus an entrepreneurial profit derives an indication of value. The cost approach is useful for financing construction projects only to the degree that it tests the reasonableness of the project’s cost, not its true value.

  • Sales comparison approach: Compare the property being appraised with similar properties that have been sold recently. Be careful that the comparison properties are truly comparable. Size of the lot, square footage of existing structures, and quality of infrastructure and construction are important variables. The sales comparison approach assumes that the market is efficient (or accurate) and sets the value of the real estate based on a view of supply and demand. This approach is feasible in situations in which there is a sufficient turnover volume, such as in most consumer goods, and if the different motivations of buyers and sellers are statistically reliable. The commercial real estate market may not fit this description because it is composed of a large number of submarkets with low turnover rates and a limited number of buyers and sellers.

  • Income capitalization approach: Ask the question, How much money can I make operating my franchise on this property? Convert anticipated benefits—that is, cash flows—into property value by using a market-derived capitalization rate[7] or a capitalization rate reflecting a specific income pattern. The income capitalization approach is the best and most commonly used method of the three valuation types. However, this approach is only an estimate of value because the methods to ascertain the capitalization rates are unstructured, the proven cyclical nature of the real estate market is hard to anticipate, and only one value is calculated.


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