Commercial property valuation is a more complicated and much more expensive process than appraising residential real estate. Depending on the type of property, commercial appraisals can run between $2,500 to $15,000. The cost will vary based on the size, nature, and complexity of the property involved. Like residential appraisers, commercial appraisers follow standards set forth in Uniform Standards of Professional Appraisal Practice. The commercial appraisal analysis commonly uses one of the following three techniques: 1) the cost approach; 2) the sales comparison approach; or 3) the income approach.
Depending on the availability of information, one or more of these approaches may be used by the appraiser. See Tukey v. Tukey, 1992 Me. Super. LEXIS 269, at *7–8 (Me. Super. Ct. Nov. 13, 1992) (where the court discredited the appraisal offered by defendant’s expert as he inappropriately focused exclusively on the cost approach to valuation, and discredited the appraisal offered by plaintiff’s appraiser as her exclusive focus was on a marketplace approach to value). The indication of value and the relative strength or weakness of the approach developed is summarized in the section of the appraiser’s report called the “Reconciliation.”
The cost approach assumes the principle of substitution. This principle affirms that no prudent buyer would purchase a property for more than it would cost to purchase a site and construct a property of similar desirability and utility. The cost approach is particularly applicable when the property being appraised involves relatively new improvements that represent the highest and best use of the land. The cost approach is rarely used to value commercial real estate because the cost of new construction generally exceeds the valuation of the commercial property for the remaining two approaches—the sales comparison approach and the income approach.
The sales comparison approach is similar to the same approach used in the valuation of residential real estate. The appraiser attempts to identify within a predetermined geographical area the identity of similar commercial property and, through market sales, develop a comparable price for the subject property. The sales comparison approach is the primary approach used in the valuation of residential property and is also frequently used in the valuation of commercial property.
By far the most common approach to the valuation of commercial real estate is the income approach. Frequently, divorcing couples own rental property as part of the marital estate. In the income capitalization approach, the current rental income of the property is calculated with deductions for vacancy and collection loss and expenses. The prospective net operating income (NOI) of the property is then estimated. To support the estimate, operating expenses for the subject property in previous years and for comparable properties are reviewed along with available operating cost estimates. An applicable capitalization method and appropriate capitalization rates are developed and used in computations that lead to an indication of value. Appraisal Institute, The Appraisal of Real Estate (Chicago 10th ed. 1992).
The income approach is based on the premise that a buyer will pay for anticipated future dollars that may reasonably be expected to be generated by a rental property. The process is broken down into four essential steps:
Step 1: Estimating the potential gross income a property can generate.
Step 2: Estimating the effective gross income a property can generate.
Step 3: Estimating expenses and subtracting these from the effective gross income to arrive at NOI.
Step 4: Selecting a capitalization rate and capitalizing the net operating income into a statement of value.
The two most common methods of converting net income into value are direct capitalization and yield capitalization. In direct capitalization, net operating income is divided by an overall capitalization rate to indicate an opinion of market value. Although less used, the yield capitalization method looks at the anticipated future cash flows and a reversionary value which are discounted to an opinion of net present value at a chosen yield rate (internal rate of return). Investors using the yield capitalization method are generally more focused on long-term strategies than short-term cash generation.
In the rental property example, NOI is determined after deducting all operating expenses, but before deducting income taxes and interest. A capitalization rate is then selected. There are two primary methods to determine capitalization rate: the weighted band of investment and debt coverage ratio (DCR) formula. Once the capitalization rate is determined, the value of the rental property can be determined by dividing NOI by the capitalization rate (in other words, if the net operating income for rental property is $45,000 and the capitalization rate is 5 percent, the value of the rental property would be $900,000). Generally, the lower the capitalization rate, the higher the property value; the higher the capitalization rate, the lower the property value. Consider, for instance, a 9 percent capitalization rate with the same NOI of $45,000. The rental property is only worth $500,000 with a 9 percent capitalization rate. This example demonstrates how critical it is to have an accurate estimate of capitalization when valuing commercial property.
This article is the fifth installment in a series providing general information about the use of expert testimony and opinion testimony in divorce litigation. The entire chapter regarding the Use of Experts in Divorce Litigation was published by MCLE New England in February, 2016: A Practical Guide to Divorce in Maine. The Guide is available for purchase at the MCLE New England website.