There are three primary means of appraising commercial real estate: the cost approach, sales comparison approach and the income capitalization approach. Each method has value depending on the situation and type of real estate involved.
The cost approach is not commonly used. The primary assumption of this method is that the value is the same as the cost to construct the property or replacement cost. This method requires an in-depth knowledge of construction and material costs.
Sales Comparison/Market Approach
This is the method most are familiar with as it is the accepted method for valuing residential real estate. Typically this method involves selecting properties with similar characteristics in the the same market area that have recently sold. Once those properties are found they are compared to the property in question and a professional appraiser will deduct value from the subject property for comparative deficiencies and increase value for advantages. Typically this method is required if the investor is seeking conventional financing.
Income Capitalization Approach
This valuation method is a short-hand means for real estate investors to determine the value of a property based on its income in comparison to similar properties. Essentially, if the investor knows what prevailing capitalization rates are in a given market for that type of property, he can divide the income generated by the property by the capitalization rate and come up with a sales value as a result.
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