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A commercial appraisal can include many things, depending on the property type, scope of work, use and user of the appraisal, and many other factors. Generally, an appraisal will provide an overview of the current economic conditions and market area, a description of the property including the site and buildings, an analysis of the highest and best use of the property, and an in-depth discussion of the valuation from the approaches used in the appraisal.
Commercial Investment Appraisers performs appraisal and consulting services on most commercial property through the use of three narrative report types, including the Restricted-Use report format, the Summary report format, and the Self-Contained report format. The report-type used is typically based on the needs of the client, and with guidance from the appraiser, is ultimately chosen by the client as well. The three report types are as follows:
Since the average user of an appraisal may not fully understand real estate valuation, an overview is provided to describe the appraisal process. While this methodology may vary from property to property, the general underlying principals discussed herein remain consistent for most valuation of real estate.
Highest and Best Use Analysis - In order to produce a credible appraisal, the subject property must be appraised based on its highest and best use. According to The Appraisal of Real Estate, 13th Edition, highest and best use is defined as:
The reasonable probable and legal use of vacant land or an improved property, which is physically possible, appropriately supported, financially feasible, and that results in the highest value.
This definition implicitly indicates that the estimation of highest and best use considers the contribution of a specific use to the surrounding market, and the advantages of that use to the individual property owners. The determination of the highest and best use comes from the judgment and analytical skills of the appraiser, and the estimated highest and best use derived from the appraiser's analysis is considered only an opinion, not fact. The concept of highest and best use is the foundation in which value is based, according to appraisal theory.
Identifying the motivation of a probable purchaser is included in determining the highest and best use of a property. This motivation is founded on perception of benefits that are inherent in property ownership. Different motives influence highest and best use and are primary considerations to the appraiser.
The determination of the highest and best use of a property is a sequential process. Potential uses for a property are tested as being physically possible, legally permissible, financially feasible, and maximally productive. That use which provides the highest value is the highest and best use. The four tests of highest and best use follow.
The appraiser must determine the highest and best use of the site as though it were vacant, as well as improved. When a property is improved, the highest and best use can be different from the existing use. The highest and best use as vacant is generally used to estimate the land value for the subject property.
After determining the highest and best use of the property, the valuation approaches are applied. There are typically three approaches to value in the appraisal process. The three approaches include the Cost Approach, the Sales Comparison Approach (also called Direct Sales Comparison Approach, or Market Approach), and the Income Approach (also called Income Capitalization Approach). The methodology of the appraisal process requires an unbiased analysis, calling for all three approaches to be made independently, without reliance on each other. These three approaches include the following criteria:
This approach is based on the premise that the value is derived from estimating the current replacement or reproduction cost for a property, deducting the accrued depreciation caused by the physical deterioration, functional obsolescence and/or economic obsolescence, and adding the estimated land value.
The Cost Approach is predicated on the principle of substitution, which states that a prudent buyer will not pay more for a property than the cost to build similar improvements on another site. The Cost Approach estimates the cost to replace the current improvements with improvement that have similar utility. The replacement cost new is then depreciated and the land value, estimated using the Sales Comparison Approach, is added to the depreciated replacement cost for the total value. The following are the three major forms of depreciation:
Although there are other approaches by which the value of the land may be derived, the Sales Comparison Approach is the most common and generally relied upon when sales of comparable properties are available.
This approach compares the subject property's characteristics with those of comparable properties which have recently sold in similar transactions. Dissimilarities are accounted for in the form of adjustments. This approach is most meaningful when there is adequate data involving comparable sales. The reliability of the Sales Comparison Approach varies directly with the quantity and quality of market data.
When choosing sale properties to be compared to the subject property, the comparables must have a similar highest and best use. All of the properties compared should have the capability of satisfying the requirements of the same buyer. Depending on the type of property being appraised, the Sales Comparison Approach takes on different forms; however, the methodology is basically the same. The technique used in the Sales Comparison Approach includes:
Because no two properties are identical, particularly in regard to investment real estate, it is necessary to make either quantitative or qualitative adjustments (or a combination thereof) to the unit prices of the comparable sales to reflect the value of the property being appraised. However, since true matched pairs and/or support for quantitative adjustments can be difficult to defend, qualified ranking is usually more reliable than quantified analysis, especially since buyers and sellers in the market typically make their decisions qualitatively. However, quantitative adjustments should be made to the sales when supportable.
Ultimately, the value indicators should fall within a relatively narrow range of unit prices. In the final selection of a unit price for the subject, it is improper to simply take an average of the unit prices. Instead, the process consists of analyzing the adjustments made and placing the greatest reliance on the value indicated by the most comparable properties or property.
This approach is used to estimate the value of a property by first estimating the net operating income attainable and then capitalizing that income by an appropriate capitalization or yield rate.
The Income Approach is typically utilized in the valuation of income-producing properties. The principle of anticipation is the basic underlying principle of this approach which states that the buyer or investor will pay no more than the present worth of the anticipated future benefits. This approach typically uses either direct capitalization or discounted cash flow analysis (also called yield capitalization). In direct capitalization, the net operating income the property is capable of producing is estimated and is then capitalized at a market-derived capitalization rate that reflects the risk and return characteristics of the investment. In the discounted cash flow analysis, income and expenses are analyzed for each year of the projection or holding period and the net income is discounted to the present value indication by applying an appropriate yield rate (discount factor). The value for the subject is estimated by summing the present values of cash flows during the projection period and the present value of the reversion at the end of the holding period (less typical sales costs).
Reconciliation is the process whereby the final appraised value estimate is derived from the various indications of value. The range between the value indications is examined, and then the appraisers place significant emphasis on the approach or approaches that appears to indicate the most applicable and reliable resolution to the appraisal problem. Consideration is given to 1) the purpose of the appraisal, 2) the property type, and 3) the relative adequacy and reliability of the information processed in all three approaches. The applicability, dependability, weaknesses and strengths of the approaches are considered, and a final reconciliation of market value is estimated from the approaches used.