Depending on what you are trying to achieve will determine which valuation is important. Appraisal is more art than science.
Ken Kramer is the Co-founder and Managing Director at Rushton Atlantic, LLC. Rushton provides third party appraisals, valuations, for its clients; banks, insurance companies, governments, and property owners.
Three Different Appraisal Valuation Approaches
Income: based on the income the asset can produce over the life left in the asset.
As an investor, your primary interest is the income the property can produce. Can the property generate enough income to cover its operating expenses, reserve for capital expenditures, make the mortgage payment, resulting in a profit for you?
You are likely be interested in the market value as well. Are you getting a good deal? Can you sell it for more than you paid?
Fair Market/ Market: the value agreed upon by a willing buyer and seller in a particular market.
A bank views the property from a market value. Market value of commercial real estate is a function of net operating income. The NOI divided by the local capitalization rate (cap rate) will provide a market value.
The difference between the market value and the mortgage is lender’s margin of safety. If you fail to make the mortgage payments, the lender will take the property back through foreclosure. When this happens, the bank wants to be able to sell the property quickly, which is likely at a discount near the mortgage balance.
Cost/ Replacement Cost: considers how much will it cost to replace or rebuild the property, building, with a new building.
The insurance company needs to know the replacement cost. The bank will require that you purchase insurance on the property to protect you and the bank from loss.
The best insurance coverage will provide replacement cost coverage. The insurance company will compare the limit on the policy to the amount needed when the building is damaged or destroyed. If there are no issues, the policy will pay for the building to be rebuilt, restoring your income and the asset the bank lent against.
Valuations Mean Different Things
As you can see, different parties have different valuation considerations.
The buyer, wants to know income value, and the market value.
The bank wants to know the market value.
The insurance company wants to know the replacement cost value.
Remember, appraisal is an art form. Values can move from year to year and Market Value does not equal Replacement Cost.
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