Commercial Real Estate Appraisal Income Approach

Posted on May 9, 2010 by IC N in Commercial

Commercial income properties can be valued based on the leased fee estate. The fee simple estate is appropriate for properties with leases consistent with market rent and terms. Valuation of the leased fee estate is more appropriate for properties with above market or below market rents. Valuing properties with below market rental rates based strictly upon its actual rental rates would understate its value. Valuing it using market rental rates would overstate its market value.

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Accurate data is the basis of a reliable income approach conclusion. This includes information on rental rates, occupancy rates, new construction, absorption, operating expenses and capitalization rates. Rental rates are usually obtained from rental comparables, subject property leases and aggregate market data. The same is true for occupancy rates. New construction can be obtained from personal observation while doing fieldwork, research and aggregate market data.

Operating expenses are evaluated on a line-item by line-item basis. The first step is usually to summarize the subject property’s operating expenses for a two to four year period. This is termed “spreading the data”. It tends to highlight anomalies in data. Comparable expenses and industry data (IREM and DOMA) can also be useful.

Capitalization rates are estimated based on data from recent comparable sales and discussions with market participants.

The direct capitalization method and the discounted cash flow analysis are frequently utilized to determine estimates of value for the income approach. Other techniques include gross rental multiplier (GRM) and effective gross income multiplier (EGIM).

The formula for the direct capitalization method is as follows:

Market Value = NOI / Cap Rate

NOI is net operating income. Cap rate is capitalization rate.

The formula for GRM is:

Market Value = Gross Possible Rent x GRM

GRM is gross rent multiplier. It is abstracted from market data and discussions with market participants.

The formula for EGRIM is: Market Value = effective gross income x EGIM

Effective gross income is abstracted from market data and discussions with market participants.

The discounted cash flow analysis evaluates net appreciating income and net sales proceeds and discounts these to a current indication of value.

The income approach is often given primary emphasis in appraising income properties. An appraiser “should look through the eyes” of market participants when selecting an income approach methodology. The appraiser should emulate the process of market participants rather than an alternate approach.

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Renovation / Upgrading Cost Benefit Analysis

To obtain further information for income approach analysis, contact George Thomas or Craig Young at 713-686-9955 or fill out our online form.

The appraisal division of O’Connor & Associates is a national provider of commercial property real estate appraisal services including Commercial real estate appraisal, cost segregation studies, due diligence, insurance valuations, business personal property valuations, business purchase price allocations, single family litigation support and business valuations. Appraisal services are provided for all commercial property types including 1 multi-family housing, retail stores, hospitals, hotels, industrial properties, manufacturing facilities, medical offices, commercial offices, restaurants, self-storage units, shopping malls, shopping plazas and warehouse/distribution centers.

Patrick C. O’Connor