Background

• Appraisals often value real estate assets utilizing three separate methodologies. The "Cost Approach" provides an estimate of replacement value, the "Sales Approach" generally provides a comparison of sales prices for comparable assets within the same market and the "Income Approach", which provides a projection of cashflow generated by the property. Although each of these approaches may be considered in the calculation of commercial real estate (CRE) market value, the "Income Approach" is often emphasized for an income producing property, as the cashflow analysis provides the basis for an expected income stream or investment return from the property.
  
  

Calculation

• Market Value in the Income Approach is calculated as Net Operating Income (NOI) divided by a Capitalization Rate (Cap Rate):
  
  Estimated Market Value = Net Operating Income / Capitalization Rate
  
  Net operating income can have a number of adjustments but will generally be calculated as a property's annual gross income less annual operating expenses. Cap rates are often derived using cost of borrowing or investment return assumptions and will vary by location, property type and overall market risk. An investor or appraiser calculating market value will generally review the cap rates used for recent comparable assets in a similar location.
  
  

Example

• As an example, if a commercial property had an annual net operating income of $4,000,000 and comparable sale properties in the area had a recent cap rate of 7 percent:
  
  $4,000,000 / 7 percent = $57.1 Million
  
  Market Value for the commercial property is estimated to be $57.1 Million.
  
  If the annual vacancy increased and so net operating Income decreased to $3,000,000, assuming all else was held constant:
  
  $3,000,000 / 7 percent = $42.9 Million
  
  Market Value for the commercial property is estimated to be $42.9 Million.
  
  

Changes to Value

• Any actual or projected change to either net operating income or the cap rate will result in a change to the estimated market value of the commercial property. "In an efficient market, what investors are willing to pay for a building depends on the rental income it's expected to yield," as stated in the Federal Reserve Bank of Dallas Economic Letter. Consequently, a specific commercial property sale or asking price may be considered to be above or below the property's market value as derived by a valuation approach.
  
  

Considerations

• Market value can be impacted by property specific occurrences, such as an increase in the cost of operating, insurance or repairs. Market value can also be impacted by trends in overall market conditions, which includes changes in borrowing costs, falling or rising market rent levels and increases or decreases in local market vacancies. As an example, a construction or economic expansion can lead to an oversupply of commercial property space, eventually creating downward pressure on occupancy levels, asking rents and ultimately market value for a given property class and submarket.