Understanding Real Estate Valuation: A Guide to Appraisal Approaches
What is the Economic Rationale for the Cost Approach?
Under What Conditions Would the Cost Approach Tend to Give the Best Value Estimate?
The rationale for using the cost approach to valuing (appraising) properties is that any informed buyer of real estate would not pay more for a property than what it would cost to buy the land and build the structure. The cost approach is most reliable where the structure is relatively new and depreciation does not present serious complications.
Question 10-2
What is the Economic Rationale for the Sales Comparison Approach? What Information is Necessary to Use This Approach? What Does it Mean for a Property to be Comparable?
The rationale for the market approach (otherwise known as the sales comparison approach), lies in the principle that an informed investor would never pay more for a property than what other investors have recently paid for comparable properties. The sales comparison approach to valuation is based on data provided from recent sales of properties highly comparable to the property being appraised.
For a property to be comparable, the sale must be an “arm’s-length” transaction or a sale between unrelated individuals. Sales should represent normal market transactions with no unusual circumstances, such as foreclosure, sales involving public entities, and so on.
Question 10-3
What is a Capitalization Rate? What are the Different Ways of Arriving at an Overall Rate to Use for an Appraisal?
An overall rate or overall capitalization rate is the rate on the overall property (debt and equity).
One way of arriving at an overall rate is to use the band of investment approach. This is based on taking into consideration the investment criteria of both the lender and the equity investor involved in a project. This is done by taking a weighted average of the equity dividend rate expected by the investor and the mortgage loan constant (expressed on an annual basis) required by the lender.
Two different ways of arriving at an overall rate are the direct capitalization approach and the present value method.
Question 10-4
If Investors Buy Properties Based on Expected Future Benefits, What is the Rationale for Appraising a Property Without Making Any Income or Resale Price Projections?
Using the direct capitalization approach, this technique is a very simple approach to the valuation of income-producing property. The rationale is based on the idea that at any given point in time, the current NOI produced by a property is related to its current market value.
A survey of other transactions including sales prices and NOI (NOI ÷ sales prices) indicates the cap rate that competitive investments have traded for. This survey provides cap rates that indicate what investors are currently paying relative to current income being produced. A parallel in equity securities markets would be earnings yield (or earnings per share ÷ price) or price-earnings multiples (Price ÷ earnings per share).
Question 10-5
What is the Relationship Between a Discount Rate and a Capitalization Rate?
A capitalization rate is equal to the difference between the discount rate and the expected growth in income. In other words, changes in income over the economic life of the property are ignored when using a capitalization rate.
Question 10-6
What is Meant by a Unit of Comparison? Why is it Important?
A unit of comparison is used in the sales comparison approach to valuation. To the extent that there are differences in size, scale, location, age, and quality of construction between the project being valued and recent sales of comparable properties, adjustments must be made to compensate for such differences. The appraiser must find an appropriate unit of comparison for a given property. Examples are price per square foot for an office building, price per cubic foot for warehouse space, price per bed for hospitals, or price per room for hotels.
Question 10-7
Why Do You Think Appraisers Usually Use Three Different Approaches When Estimating Value?
If perfect information was available, then theoretically the same value should result regardless of the methods chosen, be it cost, market, or income capitalization. Even with imperfect information, there should be some correspondence between the three approaches to value, which is the reason appraisal reports will typically contain estimates of value based on at least two approaches to determining value.
Question 10-8
Under What Conditions Should Financing Be Explicitly Considered When Estimating the Value of a Property?
Financing should be explicitly considered when using the mortgage-equity capitalization method. With this method, the value of a property can be estimated by explicitly taking into consideration the requirements of the mortgage lender and equity investor, hence the term “mortgage-equity capitalization