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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.
Office Property Appraisal and the Proper Valuation Techniques, Part 1
When performing a real estate appraisal for an office property, the appraiser must first understand the theories, distinctive terminology, ideologies, and analytical methods associated with office building valuation. Distinctive emphasis should be given to the income capitalization approach and the intricacies of determining a value for properties with several tenants. The appraiser should be familiar with the attributes associated with the various styles of office buildings, significant inspection concerns, and industry measurement standards. This should be followed by a detailed investigation of the income approach by examining substitute lease types, appropriate procedures for predicting office rents, vacancy rates, and operating expenses, as well as suitable methods for choosing capitalization and discount rates. The appraiser should also consider the important concerns associated with the Cost Approach as well as the Sales Comparison Approach when undertaking an appraisal of an office building. In the first part of this series we will take a look at a major issue that should be addressed when using the Sales Comparison Approach in the valuation of an Office Building.
Generally, there are number of different types of office properties in a market; therefore, it is important to be thorough when researching comparable sales within the Sales Comparison Approach. For example, there could be two sales of office building properties that are of identical size. However, one of the buildings may contain an open build-out that is intended for a single user while the other building may contain heavy partitioning and be better suited for use as a multi-tenant property. If the appraiser was working on a real estate appraisal of an owner-user office property it would mostly likely not be appropriate to use the sale of a multi-tenant property that was fully leased at the time of the sale. An adjustment could be considered to account for the difference but it would be better to find sales that were also owner-user properties.
As seen in the previous example, the applicability of any individual valuation approach in an office building is usually a function of the current or intended use of the office building. The Sales Comparison Approach is the most applicable approach in the case of an owner-user office property while the Income Approach is the most applicable approach in the case of a multi-tenant office property. Generally, the Cost Approach would not be the most applicable valuation approach unless the property consists of a new building in an emerging market with limited comparable sales and comparable rental data. In the second installment of this series we will take a closer look the use of The Income Approach in the valuation of an office building.