Determining Value by Income or Cost
In appraisal practice there are three commonly accepted approaches used in valuation of property - direct comparison, cost, and income. Which approach one uses is determined by a concept called "highest and best use". Last week we discussed using actual sales of comparable properties, a method most often used for placing values on residential and farm properties.
What if you have a small apartment building for sale? You should use the income approach. Buyers will look at this property and try to estimate its future income potential. The simplest way to do this is by the Gross Income Multiplier method; taking the building's selling price and dividing it by its gross annual income. This multiplier is then compared to other multi-family buildings that have sold in the same community to see if it is higher or lower than average. Sometimes buyers will see potential for rental increases for units in the property so may pay a little more than the GIM indicates in anticipation of managing it more effectively.
I prefer to use the capitalization rate method if the vendor cooperates by giving you accurate records on the revenue and expenses associated with the building. From this you can determine the current net operating income derived from the property, divide it by the buyer's preferred capitalization rate, which in turns provides you a target price that your client should pay (or ask).
This capitalization, or return on investment, often reflects the buyer's personal perspective on risk with that property including location and condition. In my experience, it is not unusual for buyers to seek a higher return on their money in rural communities over properties located in larger population centres. As in all investments return relates to risk.
Valuation of commercial buildings or unique properties, such as lakefront or log homes, might require the cost approach. Take current value of the land, add the today's cost of all the improvements on it, and then depreciate back to the effective age. With this method, the Realtor or appraiser has to make a judgment call about how old the property presents, instead of its actual age.
Some locations have been "rode hard and put away wet", while others have been meticulously maintained or refreshed. Structures, depending on how well they are built and with what materials, are considered to have a life cycle before requiring removal. The effective age is a proportion of that cycle applied against today's cost.
I think by now readers will realize that there are several truths about valuation of real estate. First of all, unless you have training and experience, it can be hard to get an accurate estimate. Secondly, that each property has to be specifically focused on, with the valuator alert to not only what they see, but also the environment that surrounds it. Third, there is a certain amount, and it is without a doubt an important element, that relies on the valuator's opinion being shared by buyers, sellers, and those that make their living in some aspect of real estate - Realtors, lenders, and insurance brokers included. At the end of the day, it all comes down to "willing buyer - willing seller."
Vern McClelland is an associate broker with RE/MAX of Lloydminster. For more helpful hints on buying or selling real estate visit www.vernmcclelland.com
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