When buying and selling commercial real estate, appraisers often rely on three established methods to assess the current value of a property. In communities such as San Francisco, where commercial real estate is in high demand, the value of commercial property has been driven increasingly higher alongside private real estate. With that in mind, business owners and entrepreneurs who are seeking out commercial real estate to launch their enterprises should be aware of the different parameters that affect property prices in their desired area. The three most common methods of appraising commercial real estate are the cost approach, the market approach and the income capitalization approach.
Defining the Cost Approach
According to the cost approach method of property appraisal, the value of commercial realty should equal the current expenses required to replicate the structure exactly, taking into account additional variables such as depreciation and land value. In areas of high property density, it is quite likely that the land value will figure prominently when calculating commercial real estate values using the cost approach. Depending upon the specifics of the structure in question, the value of the building itself may not factor as prominently into overall appraisal value as the land value when using the cost approach.
Defining the Market Approach
Unlike the cost approach, which focuses predominantly on the literal value of the structure in question and the land it sits on, the market approach is fundamentally derived from an analysis of the value of properties in the immediate area of a similar size and function. It does not matter specifically what method of appraisal has been used to determine the value of these neighboring properties, and instead relies almost exclusively on the fair market value of the properties themselves. As could be expected, using the market approach will likely result in a variety of pricing fluctuations if and when the relative demand in the property market shifts.
Defining the Income Capitalization Approach
Using the income capitalization approach, real estate appraisers divide the net operating income of property, also explained as all of the revenue generated by the property, by its current market value. The income capitalization approach to appraisal is widely considered to be an excellent benchmark by which real estate investors can assess the attractiveness of a property according to their own standards. For example, if a commercial real estate investment group considers a capitalization rate of 10 percent – or, in other words, a revenue-to-market value ratio of 1:10 – to be their ideal, this numerical calculation method will allow them to quickly assess the viability of properties quickly and efficiently.