Which method of valuation is the best choice when appraising a 25 unit apartment building?

It’s standard procedure for most commercial lenders to request all three approaches to value—sales comparison approach, income approach, and cost approach—be undertaken during an appraisal. Usually, there is a stipulation that an approach may be excluded from the valuation if such an approach is deemed dispensable. This omission can be a point of conflict between lenders and appraisers, as the necessity of one or more approaches is debatable in certain situations. This post attempts to clarify the instances where the cost approach is either relevant or extraneous to a property’s valuation. Being able to prudently determine the importance (or otherwise) of the cost approach to valuation increases efficiency and fosters understanding between lenders and appraisers.

What Is this Method all About

Per Investopedia, “The cost approach is a real estate valuation method that surmises that the price a buyer should pay for a piece of property should equal the cost to build an equivalent building.” Essentially, in the cost approach the market value of a property is equal to the cost of the underlying land plus the cost of new construction, minus depreciation. To assist with the cost approach, most appraisers turn to cost manuals, such as the Marshall & Swift Valuation Service, that provide pertinent information on building expenditures associated with different building types, locations, and dates of construction. The following section breaks down the ideal scenarios that require this approach to valuation in commercial appraisals.

When to Use the Cost Approach

The ideal stage to utilize the cost approach is when constructing or proposing a new property. Given that construction expenses associated with erecting a new building should be readily available to the appraiser, these costs are often the best indicator to determine a property’s value. While some buildings may be improved beyond market standards, generally, the most compelling reflection of the cost approach is when the actual price to construct a property is known. The over-improvement issue would likely be adjusted for in an associated sale comparison approach, which would then be reconciled with the cost approach to reach an appraiser’s value conclusion.

The valuation of special-use properties (such as churches, schools, libraries, or other non-income-producing buildings) usually requires the use of the cost approach. Since most of these buildings neither yield an income (and if they do, it’s often at non-market rates) nor frequently transact in some markets, the cost approach can be either the primary or the sole approach for valuation. Although calculating appropriate depreciation can be challenging in these instances, most cost manuals include reference charts to help appraisers determine the right amount of depreciation.

Often when an appraisal is ordered for insurance purposes, a cost-based valuation is required. An example of this is when an insurance company needs to know the exact amount to insure a building, which requires separating the underlying land value from the building’s worth. In this case, the cost method would be the most relevant approach to valuation.

The Cost Approach Is Not Always Relevant

For older properties, the cost approach is generally not as useful. While there are some exceptions, such as found in special-use properties, the high degree of depreciation in older buildings makes it difficult to accurately apply depreciation in the valuation. Considering this reality, buyers normally won’t consider this approach during their buying process, making it not only an unreliable approach to valuation, but also irrelevant in the market.

In some cases, the income approach and the sale comparison approach are enough to determine a property’s value without the use of a cost approach. This cost-approach exclusion tends to be especially true for income-generating properties. For example, unless it was very recently constructed, an appraisal of a multi-tenant retail building would likely exclude the cost approach. In this scenario, given the reliable data derived from the subject property’s income and expenses and the high probability that there are good supporting rent and capitalization rate comparisons in the market area, the income approach would provide the best indication of the subject’s value.

The second-best indication of the property’s value would then be determined by the sales comparison approach (also called the substitution method), again, assuming there are ample sales comparisons within the subject’s market. If there is an active market for the multi-tenant retail building mentioned above, and vacancy rates are relatively low, it is likely that there would be a large pool of buyers interested in purchasing the property. As with the case in older properties, a potential buyer for this multi-tenant retail building most likely wouldn’t consider the cost to construct a similar building in the area, unless the buyer had more specific needs. Their main concerns are the property’s income potential and the cost to acquire the property, compared to other similar properties in the area. Therefore, the cost approach would be irrelevant in the market in this situation and, thus, should be excluded from the appraisal.

Efficient Appraisals

Now that we’ve addressed some examples of when a cost approach is necessary, you’ll have a better understanding of when it’s proper to request a cost approach and when this valuation method is redundant. Identifying instances where the cost approach is not needed can ultimately increase an appraiser’s efficiency and speed up the appraisal process. The necessity of this approach should be discussed in your initial conversation with an appraiser when determining the appropriate scope of work.

When it comes to buying or selling a property for your business, the starting point is to figure out how much the property is worth. This seems simple enough – surely, you see what has previously been sold in your locality and use that as a jumping off point? Sadly, the valuation of property – and especially commercial property – is not quite so straightforward. If it were, there would be no need for professional appraisers in this field.

Market value is a professional opinion of what a property would sell for at arm's length – meaning to an independent buyer, without any concessions or kickbacks – based on the local real estate market, supply and demand, what other similar properties are selling for in the area, and the specific features and benefits of the property.

This is not the same as the market price of a property, which can be more or less than the market value. That's because the price is whatever the seller agrees to sell the property for. This could be the same as the market value, or the seller may accept a lower price for the property because, for example, he needs a quick sale.

There's also a much longer definition of market value, and that depends on the type of valuation method being used. There are three primary methods of valuation in the United States: the sales comparison approach, the cost approach and the income approach. Part of an appraiser's job is to know what method to use for a given property in a given location.

Before we look at the three approaches, bear in mind that a good percentage of a property's value is subjective. Deciding how much a property is worth is more art than science, and certain parts of the process can be a little difficult to comprehend. You could ask three different appraisers to value the same property and get three different answers.

This is especially true for a commercial property where scarcity might play a role in the property's valuation. The valuations could be tens of thousands of dollars apart in some cases!

The sales comparison approach is the most frequently used method for determining the value of residential real estate, although it is also suitable for valuing some types of commercial properties. Using this approach, the property's value is based on what similar properties have sold for recently in the same market. These properties are called "comparables" or "comps" – hence the term sales comparison approach.

2. Start by listing the features and benefits of the property, for example:

3. • Square footage.
   • Lot size.
   • Location.
   • Age.
   • Numbers of bedrooms and bathrooms (if residential).
   • If commercial, the best usage the property could be put to (for example, office, retail, warehouse).
   • Overall condition (good, average, poor).

   • Garages, pools, upgrades

     –

     anything that makes this property different from other properties in the community.

5. The next step is to find the sales prices of at least three properties that are comparable to the subject property. This means they should share some, or ideally all, of the features you've listed. Make a note of any different characteristics, such as a lower square footage – you'll need this information later.

6. If you have access to the Multiple Listing Service, you can easily pull up a list of comps. You're looking for properties that have sold in the last three to six months – real estate markets move so quickly that older sale prices will be out of date. Pay attention to the address of your comparable properties. Location is a key element in real estate appraisal, due to factors like transportation and school quality, so you're looking for properties in the same neighborhood and ideally within a couple of streets of the subject property.

7. If you don't have access to the MLS, you can find much of this information on Zillow; you'll just have to do a little more digging.

9. Once you've found your comparables, run a quick calculation to get a benchmark valuation for the subject property. For example, if you find three comparable properties that sold for $450,000, $480,000 and $435,000 respectively, you would take the average of these figures – $455,000.

10. Another option is to find a price per square foot (ppsf), which is useful if your comps are bigger or smaller than your subject property. For example, suppose the $450,000 property was 2,000 square feet (ppsf $225), the $480,000 property was 2,200 square feet (ppsf $218) and the $435,000 property was 1,950 square feet (ppsf $223). The average ppsf is $222. For a 2,300-square-foot subject property, that would equate to a baseline valuation of $510,600.

12. As explained earlier, valuing property is more art than science – and this is the point where the valuation gets subjective. Physical characteristics represent the most obvious differences between two comparable properties – one might be in better repair than the other, or one may have a garage while the other does not. Therefore, you need to adjust the price up or down to account for quality, condition, design and special features.

13. For instance, if a property on the next street sold recently but it had a view, whereas the subject property overlooks a brick wall, you may have to scale down the baseline value of the subject property. It's rudimentary, but it's the best you can do absent the experienced eye of a professional appraiser.

The cost approach starts by calculating how much the property would cost to rebuild, either as an exact replica of the current building or for the construction of a similar building with comparable features and amenities but with modern construction materials.

The appraiser then deducts an amount for accrued depreciation, which represents the reduction in the value of the property over time as a result of obsolescence or wear and tear. The theory here is that no one would pay more for an existing property than it would cost to build the same property from scratch.

The cost approach is favored in newer construction or for valuing special-use properties where there aren't enough similar properties for comparison. If you're valuing a commercial property, industrial property or bare land, then this is may be the most reliable approach.

2. Direct comparison is the most common method for estimating the value of vacant land – what have other plots recently sold for? For example, use a land value estimator of $50,000.

4. Ideally, you'll sum up the cost of all the separate construction components such as the roof, frame and plumbing. However, this exercise is quite tedious and best left to cost estimators. Working with a lump-sum estimate per square foot is easier – a phone call to an architect or a construction company could help you here.

5. For instance, if it costs a construction company $100,000 to put up a 2,000-square-foot warehouse, the rate will be $50 per square foot. Multiply this rate by the building area of the subject property to obtain the construction cost. For example, suppose your warehouse is 5,000 square feet. The estimated construction cost will be $250,000 (5,000 x 50).

7. Depreciation represents the loss in value as a property ages over time, either due to wear and tear or loss of utility – a modern office will be wired up to handle modern communication methods, for example, whereas a 40-year-old building may not be. The simplest depreciation method is the age-life method, which estimates how far the property is along its useful life. For instance, if the property is 10 years old and has a useful economic life of 40 years, the construction value should be depreciated by 25 percent. In this example, that leaves you with a construction cost of $187,500.

9. Finally, add the land value to the depreciated construction cost of the building. Here, the property value is $50,000 + $187,500 = $237,500.

If the subject property is leased and income-producing, you have the option of valuing it using the income approach. This method uses the property's rental income, or potential for income, to substantiate its market value. Apartment buildings and duplexes are examples of properties that you might value using the income approach.

This method gets a little complicated, and whole books have been written on how to do it.

Here's the abbreviated version:

2. The net annual income is the lease income from tenants and occupiers. If the building is empty or partially empty, you'll have to estimate this figure. Be sure to take vacancies into account. With a multi-unit apartment complex, for example, you might estimate that 20 percent of the units will be vacant for at least one month of the year to allow for tenant turnover. As such, the actual rental income will be lower than the headline figure, which assumes the building is always fully occupied.

3. For this example, imagine you're valuing an apartment complex that generates $500,000 in rental income per year.

5. Net operating income equals revenue from the property minus all reasonably necessary operating expenses, such as maintenance, utilities, property taxes, collections activity and property manager's fees. In this example, expenses add up to $100,000. Consequently, the NOI works out to $400,000.

7. The capitalization or "cap" rate is the rate of return you're expecting to get from the property based on the rental income. The cap rate formula is NOI divided by the value of the property. Here, you do not know the value of the property – since that's what you're trying to calculate. You therefore have to work backward and start with the cap rate or yield you want to achieve for your investment.

8. As a potential buyer, you might decide that an 8 percent yield is average in this market, and that's what you want to get from this property purchase. If you can't negotiate a price that achieves that rate, then you'll look for a more profitable investment.

10. Divide the NOI by the cap rate to arrive at the value of the property. The valuation for this apartment building would be $400,000 divided by 8 percent (0.08), or $5 million.