Question

List and explain what the three distinct and different approaches appraisers use to calculate estimated value of properties. Differentiate between Residential and Commercial Properties.

Answer 1

Sales comparison approach

The sales comparison approach is the most commonly used approach in real estate appraisal practice for determining the value. In this approach to value, the property which is being appraised is compared to recently sold properties which are of similar types. This is done for deriving a value indication. For that, the property being appraised is compared to comparables that are adjusted for size, acreage, amenities, time, etc. The appraiser’s experience is important when it comes to understanding the adjustments which are reasonable for a particular market area. The value of one property in a certain area may be high but it may not be of that value in a different area.

This approach to value is usually used for valuation of vacant land, improved properties or lands considered to be vacant. This approach is preferable when there is sufficient availability of comparable sales.

Cost approach

The cost approach to value estimates the value of a property by determining the cost that will be required for constructing a replacement or reproduction of the same property after deduction of accrued depreciation. Accrued depreciation means decline in the property’s actual value over the period of time due obsolescence or wear and tear.

Income capitalization approach

This approach to value is used to derive a value indication for a property that generates income. This is done by finding property value by converting the anticipated benefits. This conversion can be done in two ways. The income expectancy of one year can be capitalized at market-derived rate of capitalization or rate of capitalization that shows a specified return on investment, income pattern and change in the investment’s value. Again, at specified yield rate, the yearly cash flows for holding period and reversion can be discounted. In this approach, the future benefits of a property’s present value are estimated.

Based on the factors above, lets look at why residential and commercial properties are not the same.

1. Residential

• Residential tenants are available regardless of the economic condition. This is because most people want to live and rent in places close to their friends, families, job location, educational institutions, etc.
• Investing in rental homes also guarantees available cash flow and easier to rent. Even if a tenant leaves, there are always new tenants coming in.
• Furthermore, it is easy to sell houses than commercial lots because demand from buyers is always there.
• House rentals are determined by comparable market rates of similar houses in the area. Tenants pay their rents on a weekly or monthly basis depending on different countries.
• The value of a residential property is calculated by comparing the market price of similar properties in that location. An appraiser is responsible for estimating the value of a house.
• It is possible to buy a residential property with a small down payment and getting 90 percent or more mortgage financing from the bank.
• Rental lease is fairly standard, short and easy to understand. Landlords and tenants should not have difficulty in understanding these documents.
• Residential and commercial properties tend to have different lease periods. The length of the lease for residential is short (1 to 2 years) and tenants can extend their stay or leave when the lease expires.
• The problem with some residential tenants is that they don’t pay their rents on time. Besides, some won’t even leave when they are asked to. This makes the eviction process a little difficult.

2. Commercial

• Commercial properties tend to be more lucrative than residential because of steady returns and better cash flow.
• Tenants in commercial properties usually pay expenses such as repairs and maintenance. This is because tenants want to run their businesses as good as possible.
• The lease period are longer than residential, which translates into guaranteed long-term cash flow. Landlords can lease to a tenant for a specific length of time (e.g. 5 years) and then have the option exercised by the tenant to renew the lease for another period of 5 years.
• The lease document itself is quite long and contains many clauses. You need to study the lease carefully and understand the terms with the help of a competent lawyer.
• Unlike residential, leases are very important as these documents determine the price, value, and most importantly the rents of a commercial property. Tenants who have long-term leases can significantly improve the value of the property.
• Besides, the leases are reviewed at the end of the each period for either renewal or termination. Except for unforeseen circumstances like bankruptcy and poor sales that lead to tenants leave, most are willing to renew for long periods.
• Another advantage for commercial leases is that you can add clauses and conditions when necessary, provided the condition benefits both you and the tenant.
• Since most commercial tenants run their premises for business purposes, a drop in the economy may cause many problems, resulting in loss of income and eventually loss of businesses.

  When that happens, they leave and landlords need to find new tenants while covering the outgoing costs during vacancy for quite a long period. Therefore Vacancy rates for commercial properties are higher.

• Most banks are willing to loan more for the housing market (around 75% or more) but less on commercial market (60% or less).
• When it comes to mortgages, residential and commercial loans are also different with various financing options catering for each type of investment.

  Therefore, investors need to have greater knowledge, experience, and enough cash reserves to invest in commercial properties because of higher risks.

• Commercial leases are also powerful when it comes to rent payments. Unpaid rents can result in rent penalty and consequently eviction.
• Both residential and commercial property owners can experience some bad tenants, except that the latter has the upper hand. When it comes to eviction, the landlord have the right to remove the tenant by performing specific actions (e.g. changing locks, seize premise) according to the lease document.