The Three Approaches to Valuing Real Estate
There are three internationally accepted methods for measuring a property’s value: the cost approach, the sales (direct) comparison approach, and the income approach. Depending on the nature of the property being valued, one or more of these approaches may be used by the appraiser.
The cost approach is based on the idea that market participants correlate value to cost. The approach derives a property’s value by (a) adding the estimated value of the land to the current cost of constructing a reproduction or replacement for that land’s improvements and then (b) subtracting the amount of depreciation accrued by the property’s improvement(s), regardless of cause. The current cost of constructing improvements can be obtained from cost estimators, cost manuals, builders, and contractors. There are three types of depreciation (physical deterioration, functional obsolescence, and external obsolescence) which can be measured by conducting market research and applying specific procedures. Entrepreneurial profit and/or incentive may be included in the indicated value. Land value is estimated separately in the cost approach.
The cost approach is particularly useful for valuing new or nearly new improvements and properties not frequently exchanged in the market. Costing approach techniques can also be used to obtain information needed for the direct (sales) and income capitalization approaches to value, such as adjusting cost to cure items subjected to deferred maintenance.
This approach is particularly useful in valuing new or nearly new improvements and properties that are not frequently exchanged in the market. Cost approach techniques can also be employed to derive information needed in the sales comparison and income capitalization approaches to value, such as an adjustment for the cost to cure items of deferred maintenance.
Sales (Direct) Comparison Approach
Income-producing real estate is typically purchased as an investment, and earning power is the critical element affecting property value from an investor’s point of view. In the income capitalization approach, value is measured as the present value of the future benefits of property ownership. There are two methods of income capitalization: direct capitalization and yield capitalization. In direct capitalization, the relationship between one year’s income and value is reflected in either a capitalization rate or an income multiplier. In yield capitalization, the relationship between several years’ stabilized income and a reversionary value at the end of a designated period is reflected in a yield rate. The most common application of yield capitalization is discounted cash flow analysis. Given the significant differences in how and when properties generate income, there are many variations in both direct and yield capitalization procedures.
For the income capitalization approach, the specific data an appraiser investigates might include the property’s gross income expectancy (based on either market or contract rent); the expected reduction in gross income caused by vacancy and collection loss; the anticipated annual operating expenses; the pattern and duration of the property’s income stream; and the anticipated reversionary value. After income and expenses are estimated, the income streams are capitalized (by applying an appropriate rate or factor) and then converted into a present value (through discounting). The rates used for capitalization or discounting are derived from acceptable rates of return. In discounted cash-flow analysis, the quantity, variability, timing and duration of a set of periodic incomes, and the quantity and timing of the reversion are specified and discounted to a present value at a specified yield rate.