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REAL ESTATE VALUATION METHODS

COST APPROACH
The cost approach method is based on the
assumption that a potential buyer of a property
should pay a price that is equal to the cost of
constructing an equivalent building.
The market value of a real estate property is the
sum of the value of the land and site
improvements on the land, less any accrued
depreciation.
The cost approach is appropriate for unique
properties, such as churches or schools with
unique components.
The formula for calculating the cost approach is as
follows:
 
Property Value = Replacement/Reproduction
Cost -{Depreciation + Land Value}
Since the cost approach is not based on
comparable properties or the property’s ability to
generate revenues, the method considers the
amount that will be incurred to build a property
today, assuming that the existing structure is to
be destroyed and rebuilt afresh. Hence, it takes
into account the value of the land where the
property is built, less any loss in value.
STEPS IN THE COST APPROACH METHOD
The following is the process of the cost approach method of
real estate valuation:
STEP 1. Estimate the reproduction or replacement
cost of the structure
The step involves estimating the current cost of building the
structure from scratch and the site improvements. The
cost can be estimated using the following two methods:
• Replacement method
The replacement method estimates the cost of constructing a
building with the same utility as the structure being
evaluated, using the current construction materials,
standards, designs, and layouts.
• Reproduction method
The reproduction method estimates the cost of constructing
a duplicate of the property, using similar materials and
construction practices. It also uses the designs, standards,
and layouts that were in place at the time the property
was constructed.
The older and more historic a property is, the higher the
difference between the replacement and reproduction
costs. Building a duplicate property of a historical building
is more expensive than duplicating a modern home
because it will cost more to buy materials and undertake
site improvements.
For a newly built property, there is no major difference
between the replacement and reproduction costs. For
example, assume that the reproduction/replacement cost
is estimated to be $1 million.
STEP 2. Estimate the depreciation of the improvements
Depreciation is the loss in value of the building and or its
improvements, and it causes the difference between the
value of improvements and the current contributing value of
the improvements. When estimating the depreciation of the
property, you should consider the physical, functional, and
economic depreciation.
Physical depreciation refers to the wear and tear that occurs as
the building ages, while functional depreciation occurs with
the changes in consumer tastes and preferences over a
period of time.
Economic depreciation results from external negative trends,
such as the collapse of major employers, recession, and new
negative developments (such as the construction of a sewer
treatment plant in the neighborhood). In this case, let us
assume that the accrued depreciation is $150,000.
STEP 3. Estimate the market value of land
The next step is to estimate the value of the land
on which the property is being built. The most
appropriate method of estimating the land value
is the direct comparison method, where the
current price of land is obtained from the value
of recently sold plots of land. It is the market
value that you would pay for the land today if it
was vacant. In this case, let us assume that the
market value of the land is $750,000.
Deduct accrued depreciation from the
reproduction/replacement cost
 
After obtaining the total value of depreciation of the
improvements, deduct the figure from the estimated
reproduction or replacement cost obtained in step one. In
our case, it is calculated as follows:

Replacement/Reproduction Cost
$1,000 000
Less: Accrued Depreciation
$150,000
Depreciated Cost of the Structure
$850,000
Add the depreciated cost of the structure to the estimated
value of the land
 
The final step is to add the depreciated cost of the structure
and improvements to the estimated value of the land. The
figure is obtained as follows:
Replacement/Reproduction Cost
$1,000,000
Less: Accrued Depreciation
$150,000
Depreciated Cost of the Structure
$850,000
Add: Estimated Value of the Land
$750,000
Total Value of the Real Estate Property
$1,600,000
Limitations of the Cost Approach
One of the limitations of the cost approach is that it assumes
that the buyer is in a position to find a vacant plot of land
where to build an identical property, and that is not always
the case. If there is no vacant land, the estimated value of
the property will be inaccurate.
Also, an area can be fully developed, and local authorities can
be restrictive on new developments, and so it will be
impractical to estimate land values in that area.
Another limitation is that it will be difficult to estimate the
depreciation of older properties because there are many
factors to take into account. For example, construction
materials used during the construction of older property
may no longer be available or in use. Estimating the value
of such a property allows a lot of room for subjectivity.
INCOME APPROACH METHOD

It estimates the market value of a property based

on the income of the property. The income
approach is an application of discounted cash
flow analysis in finance. With the income
approach, a property’s value today is the
present value of the future cash flows the owner
can expect to receive.
Since it relies on receiving rental income, this
approach is most common for commercial
properties with tenants.
There are two methods for capitalizing future
income into a present value:
 Direct capitalization method
 Yield capitalization method.
The difference is that the direct capitalization
method estimates value using a single year’s
income while the yield capitalization method
incorporates income over a multi-year holding
period.
• The Direct Capitalization Method
The direct capitalization method estimates
property value using a single year’s income
forecast. The income measure can be Potential
Gross Income, Effective Gross Income, or Net
Operating Income. Direct capitalization requires
that there is good, recent sales data from
comparable properties. The comparable sales
provide the appropriate market multiplier to use
with the subject property. You can find the
average market multiplier after finding
reasonable comparable sales data. The
following formulas are three ways to find the
market multiplier using different measures of
income:
Potential Gross Income Multiplier (PGIM) = sales price /
PGI
Effective Gross Income Multiplier (EGIM) = sales price /
EGI
Net Income Multiplier (NIM) = sales price / NOI
After finding the market multiplier, multiply the
subject property’s forecasted income by the
market multiplier. For example, multiplying the
market PGIM by the subject property’s
forecasted PGI in the next year yields the
current subject value estimate. Direct
capitalization requires that the income and
expense ratios are similar for the comparables
and the subject property and that the next
year’s income is representative of future years.
• The Yield Capitalization Method
The yield capitalization method is a more
complex approach to valuation. This method
uses net operating income estimates for a
typical investment holding period. Therefore,
the resulting property value accounts for
future expected changes in rental rates,
vacancy, and operating expenses. Yield
capitalization doesn’t require stable and
unchanging market conditions over the holding
period. The yield capitalization method also
includes an estimate of the expected sales
price at the end of the holding period.
Components of the Yield Capitalization Method
Using the yield capitalization method, the subject
value estimate is the present value of the future
expected cash flows. The present value formula
simply sums the future cash flows (P) after
discounting them back to the present time.
Applying this formula, the cash flows are the
proforma estimates of net operating income (P1
through Pn), the required rate of return is r, and n is
the holding period. Although the formula calculates
present value (PV), it should be noted that both
Excel and popular financial calculators utilize the
net present value (NPV) formula to find the present
value of uneven cash flows. This works because you
can simply plug in $0 for the initial investment
amount, and then the resulting net present value
amount will equal the present value.
Cash Flow Forecasts.
Forecasting the cash flows that an income-
producing property will generate over the next
year is relatively straightforward and accurate.
Properties already have tenants with leases in
place, and costs should not vary dramatically
from their current levels. The more challenge
part of cash flow forecasting comes when
considering what happens to cash flows over the
next couple of years. In addition, any forecasting
errors in one year tend to compound themselves
in the subsequent years. Holding periods of 5-10
years are the most common, and those estimates
require forecasting future market rent, vacancy
and collection loss, and operating expenses.
Resale Value. Calculations using the income approach
assume that the owner sells the subject property at
the end of the holding period. Appraisers can
estimate resale value using a direct dollar forecast or
an average expected annual growth rate in property
values. Direct dollar forecasts are not preferred
because they don’t directly account for any market
expectations. Growth rates consider forecasted
market growth rates, but the subject property’s value
may grow at a rate that differs from the market
average.
A third method applies direct capitalization
techniques to the end of the holding
period. For example, an appraiser
considering a five-year holding period
would extend the proforma cash flow
estimates one additional year. The
expected sales price at the end of the fifth
year would equal the NOI in the sixth year
divided by a market capitalization rate.
Discount Rates. In corporate finance, the
discount rate in a net present value calculation
is usually the firm’s weighted average cost of
capital. When valuing an investment, however,
the discount rate is usually represented as the
required rate of return. Real estate investors
may use the required rate of return on their
investment properties or the expected rate of
return on an equivalent-risk investment.
One of the benefits of direct capitalization is that it
provides a way to get a quick valuation estimate.
Appraisers can quickly get a market multiplier
from recently sold property transactions. Consider
two recently sold comparables, one with PGI of
$300,000 and a sales price of $2.1 million and
another with a PGI of $225,000 and a sales price
of $1.8 million. The first yields a PGIM of 7
($2,100,000/$300,000) while the second yields a
PGIM of 8 ($1,800,000/$225,000). So, the market
average PGIM of 7.5 can be applied to a subject
property’s PGI estimate to provide a quick
valuation. If a subject property’s expected PGI
next year is $195,000, multiply that by the
market PGIM to estimate the subject value.
Subject Value = $195,000 x 7.5 = $1,462,500
The portion of the property’s NOI that is
generated by the land can be calculated
by multiplying the land value and land
capitalization rate. The remaining
income is attributed to the
improvements.
Income Approach Example Using Yield Capitalization
In order to estimate the subject property value using the income
approach, the first step is to create a proforma cash flow statement
for the anticipated holding period. Using the following market
assumptions, let’s estimate the cash flows to the owner over a five-
year holding period.
 
The subject property is expected to yield PGI of $200,000 over the
next year and currently has a 5% vacancy rate. Operating expenses
are currently 45% of EGI, and that is expected to stay the same
during the holding period.
Market rent is currently increasing at a rate of 3% per year. During the
second year, however, it is expected to only grow at a rate of 1%
before returning to the current 3% growth rate.
The vacancy rate is expected to climb to 7% during the following two
years and then return to a stable 5%.
The terminal capitalization rate of 9% is estimated from current market
cap rates.
This is the proforma cash flow statement under the given market
assumptions. The sales price in year 5 is year 6 NOI divided by the
capitalization rate.
Income Approach Example
Now we can compute the present value by
discounting the future cash flows back to the
present given the following
Investor’s required rate of return of 12%.
The cash flows are
$104,500 in year 1,
$103,323 in year 2,
$106,423 in year 3,
$111,973 in year 4, and
$1,435,241 (the sum of NOI in year 5 and the
expected resale value) in year 5. Therefore the
subject value estimate is $1,136,977
Income approach
The income approach to property valuation is based on the
principle that the value of a property is related to its
ability to produce cash flow. When attempting to estimate
value using this approach, the analyst must take into
account the many market influences that affect cash flows
as well as extracting data from the sale of competitive
properties deemed comparable to the property being
evaluated. The focus of these techniques is to determine
a market value that is consistent with prices being paid
for comparable properties trading in the marketplace. This
approach treats the net operating income or NOI from the
property as perpetuity. This perpetual stream is
discounted at a market required rate of return and is
known as the market capitalization rate or cap rate.
Market cap rate is the rate that is used by the market in
recent transactions to capitalize future income into a
present market value.
NOI= Gross Potential Income – Expenses (estimated
vacancy, collection losses, insurance, tax, utilities,
repairs and maintenance)
Appraisal Price= NOI/ Market rate cap
The market rate cap on benchmark transactions are:
Market rate cap= Benchmark NOI/Benchmark
transaction price.
The benchmark here refers to a similar/comparable
property, or the mean or median of many
comparable properties.
Basic assumptions
• The income approach assumes a constant and
perpetual stream of income from the property.
• Inflation could impact the NOI over time in the
sense that the NOI would grow at the rate of
inflation. The market cap rate accounts for
inflation. Since inflation is passed through,
valuation stays unaffected. This is however not
true for spaces on lease. Lease periods do not
allow for inflation to be passed through on an
annual basis. In the income approach all
calculations are before tax, which is a limitation.
Example of income approach
A property holder wants to sell his
apartment complex. He learns that a
commercial building and another
apartment in the vicinity were recently
sold. Using the income approach, the
value of the apartment complex can be
calculated as follows:
PARTICULARS APARTMENT RECENTLY SOLD
UNDER APARTMENT
CONSIDERATIO
N
Gross potential rental 1,000,000  
income
Estimated vacancy and 5%  
collection losses

Insurance and taxes 100,000  

utilities 50,000  
Repairs and maintenance 250,000  
Net operating income   500,000
Sales price   4,500,000
PARTICULAR DEBIT CREDIT
Gross potential   1,000,000
rental income
Estimated 5%  
vacancy and (50,000)
collection losses
Insurance and 100,000  
taxes
utilities 50,000  
Repairs and 250,000  (450,000) 550,000
maintenance
Net operating   500,000
income
Sales price   4,500,000

Cap rate (NOI/SALE RATE) 0.1111111

APPRIASAL PRICE 4,950,000