What appraisal method is used for commercial property?

Commercial properties are typically appraised using three primary methods: the Income Capitalization Approach, the Sales Comparison Approach, and the Cost Approach. Each method serves different purposes depending on the nature of the property being appraised. Here's a breakdown of each approach:

1. Income Capitalization Approach
This is the most commonly used method for appraising income-generating commercial properties, such as office buildings, retail spaces, and apartment complexes. The income approach estimates the value of the property based on its potential to generate revenue.

• Direct Capitalization: The appraiser calculates the property's Net Operating Income (NOI), which is the annual income generated by the property after operating expenses but before debt service and taxes. The NOI is then divided by a capitalization rate (cap rate), which is a market-derived rate reflecting the property's risk and return. The formula is:

Property Value=NOICap RateProperty Value=Cap RateNOI

• Discounted Cash Flow (DCF): In this approach, the appraiser projects the property's cash flows over a set period (typically 5-10 years) and discounts these future cash flows to their present value using a discount rate.

2. Sales Comparison Approach
The sales comparison approach (or market approach) is based on comparing the subject property to similar properties (known as "comparables" or "comps") that have recently sold in the same market. Adjustments are made to account for differences between the subject property and the comparables, such as location, size, condition, and features.

This method works best for properties where there is a large pool of comparable sales data, like office spaces, retail buildings, or industrial warehouses. Appraisers analyze recent sales of similar properties, making adjustments to reflect the unique characteristics of the subject property.

3. Cost Approach
The cost approach is often used for new or specialized properties where there may not be many comparable sales, such as unique industrial facilities, hotels, or hospitals. It estimates the cost to replace or reproduce the property (less depreciation) plus the land value.

• Reproduction Cost: This refers to the cost of constructing an exact replica of the property using the same materials and design.
• Replacement Cost: This refers to the cost of constructing a similar property with modern construction materials and techniques.
  

Once the replacement or reproduction cost is estimated, the appraiser deducts for physical depreciation (wear and tear), functional obsolescence (outdated design or layout), and external obsolescence (factors outside the property, such as economic conditions or zoning changes).

Finally, the value of the land is added to arrive at the total property value.

Which Method to Use?

• Income Approach: Best for income-generating properties, such as offices, multifamily housing, and retail spaces.
• Sales Comparison Approach: Ideal when there are recent sales of similar properties, particularly for smaller commercial properties or in active markets.
• Cost Approach: Typically used for new, unique, or special-use properties where income data or comparable sales are limited.

Often, appraisers will use a combination of these methods, depending on the nature of the property and available data, to arrive at the most accurate and fair value.