The Commercial Appraisal Process Explained - Commercial Appraisers Serving Southern California
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The Commercial Appraisal Process Explained

Real Estate Appraiser Orange County

The Commercial Appraisal Process Explained

Highest and Best Use, The Cost Approach, the Sales Comparison Approach, The Income Approach; what are they, when when does the commercial appraiser use them and how do they relate to your property. In this article we explain the the commercial appraisal process and how the commercial appraiser develops a value conclusion using each of the three approaches to value.

The appraisal process typically involves three approaches to value. These approaches are based on the following three facets of value:

Cost Approach

The current cost of replacing a property less losses in value from deterioration and functional and economic obsolescence (accrued depreciation).

Sales Comparison Approach

The value indicated by recent sales of comparable properties in the marketplace.

Income Capitalization Approach

The market value that the property’s net earning power will support based upon a capitalization of net income, stabilization, and residual equity buildup.

The requisites of the appraisal process call for approaches made independently of each other, specifically a Cost Approach, a Sales Comparison Approach, and an Income Capitalization Approach. The Cost Approach assumes that a property’s value is equivalent to its replacement cost, less accrued depreciation and obsolescence. This falls under the theory of substitution where the rationalization of its support is premised upon the assumption that a property’s optimum value cannot exceed the cost of duplicating the property on a similar site.

The Sales Comparison/Market Approach is determined by direct units of comparison where value can be converted to price per square foot, acres, rooms, units, or income multipliers and overall rates. The theory is that a prudent investor would pay no more for a given facility/property than what the typical market purchaser would pay for a comparable facility, all things being equal.

The Income Capitalization Approach is derived from the rationalization of substitution, where the price one would pay for a property equals the attributable value of its earning ability where measured by the yield an investor will obtain.

The final step in the appraisal process is the reconciliation of value indications. This is the consideration of the indicated value resulting from each of the three approaches. The appraiser considers the relative applicability of each of the three approaches to arrive at the final estimate of defined value.

The individual nature of the real property leads to a question of determining the most appropriate appraisal procedure for valuation. Although this cannot be easily answered, the subject is real property, and as such, market value can be estimated.

After examining the range between the value indications, the appraiser places major emphasis on the one, or on those, which appear to produce the most reliable and applicable solution to the specific appraisal task. One takes into account the purpose of the appraisal, the type of property, and the adequacy and relative reliability of the data processed in each of the three approaches. These considerations influence the weight to be given to each approach. But in order to appraise the property, the appraiser must first determine the highest and best use of the property.

Highest and Best Use

A Property Must Be Appraised In Terms Of It’s Highest And Best Use. According To The Appraisal Of Real Estate, Tenth Edition, Page 275, Copyright 1992, By The Appraisal Institute. The Definition Of Highest And Best Use Is As Follows:

The reasonable probable and legal use of vacant land or an improved property, which is physically possible, appropriately supported, financially feasible, and that results in the highest value.

When a site contains improvements, the highest and best use may be determined to be different from the existing use. Implied in this definition is that the determination of highest and best use takes into account the contribution of a specific use to the community and community development goals, as well as the benefits of that use to individual property owners. An additional implication is that the determination of highest and best use results from the appraiser’s judgment and analytical skills; that is, the use determined from analysis represents an opinion, not a fact to be found. In appraisal practice, the concept of highest and best use represents the premise upon which value is based. In the context of most probable selling price, another appropriate term to reflect highest and best use would be the most probable use.

Any determination of highest and best use includes identifying the motivations of probable purchasers. The motivations are based on perceptions of benefits that accrue to property ownership. Different motivations influence the highest and best use and are significant to an appraiser’s conclusions about the highest and best uses of any parcel of real estate.

The benefits of investment properties that are not owner occupied relate to net income potential and to eventual resale or refinancing. The highest and best use decision for investment property is often influenced by the income tax and inflation hedge aspects of the existing or proposed improvements. Determination of the type and intensity of the improvement to be placed on the investor’s land often requires an after-tax return analysis of various alternatives.

Land or improved property that has resale profit as it’s principal potential benefit is purely speculative. The price such land commands in the market reflects the real motivation of the purchaser/speculator.

This portion of the appraisal process is based on the definition of Highest and Best Use supplied previously. From this definition, it is obvious that market value of the land or site and of an improved property are both estimated under the assumption that potential purchasers will pay prices that reflect their analysis of the most profitable use of both land, as vacant, and property, as improved.

A use must meet four criteria as follows: (1) Physically Possible; (2) Legally Permissible; (3) Financially Feasible; (4) Maximally Productive.

Once The Highest And Best Use Has Been Determined, The Appraiser Can Then Apply The Appropriate Approaches To Value. Following Is A Brief Discussion Of Each Approach.

The estimated reproduction or replacement cost of any improvement, less accrued depreciation, plus the value of the land established via the direct comparison approach (Market Approach) produces an estimate of value of the subject property by the Cost Approach. A summary of the cost approach is as follows. The Cost Approach to Value basically consists of four steps:

1. Estimate the value of the land considered as vacant and available for utilization at it’s highest and best use.

2. Estimate the reproduction or replacement cost new of the improvements as of the date of the appraisal, plus the entrepreneur’s profit and any other related development cost.

3. Estimate the contributory value of improvements by deduction of all forms of accrued depreciation. The following are the three major forms of depreciation.

A. Physical deterioration, curable and incurable.

B. Functional obsolescence, curable and incurable.

C. External obsolescence, typically incurable.

4. Add land value to the contributory value of improvements for an indication of market value.

Sales Comparison Approach: The Sales Comparison Approach is the method of appraisal in which the value of a property is inferred from sales of comparable property. It is also known as the comparative or comparable sales approach, the comparison method, or the market data approach to value. Value is measured by observing what comparable properties are selling for in the market.

Properties subjected to the comparison process, both subject and comparables, must have at least the potential of a similar, if not identical, highest and best use if a valid value estimate is to result. In other words, all of the properties compared must have the capacity to satisfy the needs and desires of the same buyer. The market approach to value takes different forms, depending upon the type of property being appraised, but the method is essentially the same. This technique can be expressed as follows:

1. Describe and classify asset: The description of the property under appraisement should only cover those attributes that are significant and relevant to value. If the asset is of a diverse nature, it should be divided into value classes.

2. Find sales involving comparable assets: This means finding comparable properties that have been sold recently in the subject community. Verification and documentation of the sales is highly important.

3. Select appropriate units of comparison: The basis of the market approach to value is a comparison of one asset to another. Before a comparison can occur, a unit of comparison must be established. Appropriate units of comparison for the assessment of income properties are often established using a per net rentable square foot value. With improved property, sales are broken down into useful units so that reasonable and logical comparisons can be made. The most common three other comparisons are:

A. Effective Gross Income Multiplier: This is the sales price divided by the effective gross scheduled income of the investment facility at stabilized occupancy. Abbreviation: EGIM

B. Net Operating Income: This is the gross scheduled income less vacancy and less operating expenses, but without consideration to interest, loan amortization, depreciation, or income taxes. Abbreviation: NOI

C. Overall Rate: This is a single year’s rate between net operating income and total price. It is computed by dividing the NOI by the gross selling price. Abbreviation: OAR

4. Compare each sold asset with the subject property, adjust for differences to indicate market value of the subject asset in each comparison: Every piece of real estate is unique unto itself, so there will never be a sold property that is identical in every respect to the subject property. The appraiser searches for those comparable sales that have the most in common. There will, however, be areas of difference. These areas of difference break down into two categories, namely tangible and intangible.

Intangible differences would include terms, time, and condition of sale. Tangible differences would include location (with regard to streets, visibility, traffic patterns, and volumes, growth trends, etc.), size, zoning, age, nature, quality, and condition of improvements, etc. If a material difference is found between the sold property and the subject property under appraisement, it is necessary to adjust for the difference.

5. Find central tendency of indicated values: After making the comparisons, each sale will have provided an indicated value for the subject property. From this array of indicated prices, the appraiser must distill a single figure. Judgment is more useful than mathematics in arriving at this conclusion, because some of the comparable sales will carry more weight than others. The value indications must be reconciled into a single indicator of value for the comparative sales approach. Hopefully the value indicators will be within a narrow range. In selecting the single value estimate, it is not proper to simply average the results. Rather, the process is one of reviewing the adjustments made and placing the greatest reliance on the value indicated by the most comparable properties or property.

Income Approach: The Income Approach to value assumes a positive relationship between a property’s current market value and the expected net cash flow that the property will provide, and a negative relationship between a property’s current market value and the relative risk involved in achieving the expected cash flow. Commercial real estate are typically valued in relation to their ability to produce income. Therefore, an analysis of the property in terms of it’s ability to provide a sufficient net annual return on invested capital is an important means of valuing an asset. The two primary methods are Direct Capitalization and Yield Capitalization (Discounted Cash Flow Analysis).

In Direct Capitalization of commercial real estate, value is estimated by deducting all applicable expenses from anticipated gross income to arrive at projected net income for the coming year. This amount is then capitalized at a rate which is commensurate with the risk inherent in the ownership of the property. The capitalization rate can be derived from sales in the Sales Comparison Approach, via the Band of Investment Technique where the rates of return on mortgage and equity divisions associated with the property type are analyzed, by evaluation of debt coverage ratios, or from investor surveys. Direct Capitalization is most appropriate the appraisal of commercial property when the income stream is expected to be stabilized and market oriented through the anticipated holding period.

With respect to Yield Capitalization or Discounted Cash Flow Analysis, the appraised value is estimated by deducting all applicable expenses from anticipated gross income to arrive at projected net income during each year of the holding period. The net income stream is then discounted at a rate commensurate with the risk inherent in the ownership of the property. A reversion is computed at the end of the projection period utilizing rates commensurate with the risk of the property over the holding period and this amount is also discounted and added to the present values associated with each year of the income stream to derive an estimate of value. The Discounted Cash flow analysis involves a variety of projections relative to changes in the income stream over time as a result of changes in occupancy and inflationary factors. This method is well suited to properties with below market levels of occupancy or significant changes anticipated in the income stream over the typical holding period.

Final Reconciliation: Reconciliation is the process whereby the final appraised value estimate is derived from the various indications of value. The procedure evaluates the quantity and quality of available data and draws a conclusion based on the most applicable indicators.

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