Office Property Appraisal and the Proper Valuation Techniques, Part 2
In the second part of our look into the appraisal of Office Building properties we will begin to take a look at some of the major issues to be addressed within the Income Approach of valuation. In the Income Approach, the appraiser needs to consider expense structure, appropriate procedure for predicting office rents, occupancy rate, and the proper method for choosing capitalization and discount rates. The first decision within the Income Approach the appraiser must consider is what type of analysis to use. Typically, either direct capitalization analysis or discounted cash flow analysis is used.
The direct capitalization method converts a single year's income or an average of several years’ income expectancy into an indication of value in one direct step by dividing the income estimate by the appropriate income rate, also called the direct capitalization rate. A capitalization rate ties property value to earning ability. Direct capitalization is suitable for properties unencumbered by leases; properties encumbered by short term leases; and/or properties encumbered by leases that reflect terms similar to the market.
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). Discounted cash flow analysis is appropriate for properties with terms that differ from the market; erratic lease structures; or multi-tenant properties with a wide range in lease terms.
Typically, direct capitalization is appropriate for owner-user properties or smaller multi-tenant office properties while larger office properties typically require using a discounted cash flow analysis. Determining the correct analysis method within the Income Approach can make a significant impact in the final value of an office property. After determining the correct analysis method, the appraiser’s next step is to analyze extracted market income and expense data. In the next section of our look into the office property appraisal we will continue to look at some more issues an appraiser must address within the Income Approach.