Investment Evaluation

Highest and Best Use:

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A commercial real estate manager who analyzes real estate held for investment purposes must determine the property’s highest and best use.  Highest and best use occurs when the property produces the highest value and achieves the fullest economic potential.  The Appraisal Institute defines highest and best use as:

The reasonably probable use of vacant land or an improved property that:

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• Is physically possible.

• Is legally permissible.

• Is financially feasible.

• Results in the highest value.

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An appraiser’s view of the optimal use for the land may or may not support continued use of the building. A commercial real estate manager, on the other hand, is looking primarily for the highest and best use of the land that utilizes the existing Improvements. Some conclusions about highest and best use can be drawn from property and market analyses that detail the condition of the property and its competitive position within the market.  The use that maximizes an investment property’s value, consistent with the rate of return and associated risk expected by the owner, is the highest and best use.

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In many cases, the highest and best use is the current use.  However, the highest and best use for the property may not be in line with the owner’s current goals.  Once the study of the highest and best use has been completed, the commercial real estate manager should discuss with his client any use that is not in line with the stated goals.

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Commercial Property Evaluation 

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Professional appraisers use three approaches when conducting appraisals.  An appraiser is required to use all three approaches to value under 2004 Uniform Standards of Professional Practices (USPAP) requirements;

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• Cost Approach

• Comparable Sales Approach

• Income Capitalization Approach

 

Cost Approach

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The cost approach is a method of appraisal in which a property’s value does not exceed the Markey value of the land plus the value of the existing improvements on it.  The value of any improvements is estimated based on the cost to reproduce them minus the accrued depreciation.  Current construction prices for the existing building may be referred to as a reproduction cost or replacement cost.

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Reproduction cost is the cost at today’s prices to construct an exact duplicate of the existing building using the same type and quality of materials and construction standards, and embodying all of the characteristics, both negative and positive, of the subject property.  Newer building codes may affect this cost.

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Replacement cost is the cost at today’s prices to replace an existing building with one of equivalent utility using current materials and construction standards.  Replacement cost is the basis for the cost approach to appraisal.

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An appraiser adjusts the cost for depreciation of the existing building, taking into mind the following types of depreciation:
Physical, Functional and Economic obsolescence.

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The appraiser estimates the value of the land by using sales information on comparable undeveloped parcels.  The land value and depreciated replacement cost are added together to arrive at a cost estimate.

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Caution:  This cost approach should only be conducted by a MAI certified appraiser.

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Comparable Sales Approach 

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Using the comparable sales approach, a qualified commercial real estate professional as well as an appraiser will estimate the subject property’s current Markey value by comparing it to similar properties that have sold in that area.  Due to no two properties being exactly the same the real estate professional and the appraiser need to make adjustments on paper to bring their cost more in line with the subject property.

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The comparable sales approach is conducted as follows:

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1. The appraiser or qualified real estate professional obtain at least three comparable property sales.  The report typically shows side-by-side comparisons of the three comps.  These comparables are normally accessed for both MLS and courthouse records.

2. Must take into affect: location, size of the property, type of construction, quality of the construction, interior and exterior condition and all amenities in close proximity to the subject property.  Financing terms, market conditions, date of sale and other key features must be examined for adjustments.

3. The appraiser or real estate professional averages the adjusted sales prices of the comparable properties to arrive at a figure for the subject property.

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The comparable sales approach is best used when there is an active market for a given property type where many comparable sale are available.

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Income Capitalization Approach

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The income capitalization approach, in my opinion is the most preferred method to determine the current and future value of a commercial property.  The seller is looking to sell at the lowest cap rate and buyers are looking to purchase at the highest cap rate.

 

This method estimates the value of a property by applying a proper capitalization rate to the annual net operating income (NOI) the property is expected to produce by using the  formula :  Income (I) ÷ Rate (R) = Value (V)  The two key elements in this formula are stabilized NOI (I) and the capitalization rate (R).

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Stabilized NOI (I) is the true earning potential of the commercial property.  It reflects income achieved at full market occupancies and expenses incurred at full building operations, including full real estate tax assessments.  An accurate projected NOI is critical component in determining value.

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Buyers and sellers will look at NOI from different perspective.  Sellers will want to focus on projected future NOI, and buyers will want to focus on actual results or past NOI.

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Following are the steps involved in projecting a stabilized NOI for one year.

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1. Effective gross income is calculated.  This is done by examining Market rent level and current vacancy rates for the area.  Effective gross income is then derived from the gross potential income plus other miscellaneous income minus estimated vacancy and collection losses.

2. Forecast operating expenses.  This requires an analysis of continuous operating expenses.  Next year’s expenses are forecast from these requirements.  Unusual capital costs, such as new roof, are not included in these estimates.

3. NOI is obtained by subtracting the forecasted operating expenses from the forecasted effective gross income. Most Commercial real estate managers rely upon the income capitalization approach to estimate value of the subject property; this is the method in which they have the most information.

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The capitalization rate (R) is the rate of return used to estimate the property’s value. Cap rates are a measurement of risk used by most commercial real estate professional.

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When you're ready to buy, sell, or lease anywhere in Brevard or Indian River County, let Gene Artusa's experienced, professional, and honest hands-on approach help you attain all your real estate goals.