How to calculate the value of a building?

How to calculate the value of a building?

The valuation of a building is typically calculated using one or more of three main real estate appraisal approaches: the Sales Comparison Approach, the Cost Approach, and the Income Capitalization Approach.¹

The best method to use often depends on the type of property (e.g., residential vs. commercial), its age, and whether it’s income-producing.

1. Sales Comparison Approach (Market Approach)²

This method estimates a property’s value by comparing it to similar properties (comparables or “comps”) that have recently sold in the same local market.³ This is often the most reliable method for residential properties.

How to Calculate:

1. Find Comparable Sales: Identify several properties that are similar to the subject building in terms of size, age, condition, and location that have sold recently (ideally in the last six months).⁴

    

2. Adjust for Differences: Adjust the sales price of each comparable property to reflect any differences from the subject building.⁵

    

   • Subtract from the comparable’s price if it has a superior feature (e.g., a pool, an extra bedroom) that the subject building lacks.⁶

      

   • Add to the comparable’s price if it lacks a feature that the subject building has (e.g., a better view, a larger garage).
3. Reconcile Values: The final adjusted prices of the comparable properties should fall within a narrow range.⁷ The appraiser then weighs these adjusted values to arrive at a final estimated value for the subject property.⁸

    

2. Cost Approach

This method estimates the value by calculating the cost to replace the building brand new, subtracting any depreciation, and then adding the land value.⁹ It’s often used for new construction, unique properties (like schools or churches), or when comparable sales are scarce.¹⁰

How to Calculate:

1. Estimate Land Value: Determine the value of the vacant land as if it were ready for development, using the Sales Comparison Approach for similar vacant parcels.
2. Estimate Cost New of Improvements: Determine the current cost to construct a replacement building with the same utility as the subject building, or an exact reproduction of the original.¹¹

    

3. Estimate Depreciation: Determine the total loss in value from all causes:¹²

    

   • Physical Deterioration: Wear and tear from age and use.¹³

      

   • Functional Obsolescence: Loss in value due to outdated design, materials, or utility (e.g., small rooms, inefficient layout).¹⁴

      

   • External (Economic) Obsolescence: Loss in value due to negative factors outside the property lines (e.g., increased traffic, nearby airport noise).¹⁵

      

4. Subtract and Add: Subtract the total accrued depreciation from the estimated Cost New of Improvements, and then add the estimated Value of Land.¹⁶

    

3. Income Capitalization Approach

This method is primarily used for income-producing properties (like apartment complexes, office buildings, or rental homes) and estimates the value based on the property’s potential to generate income for an investor.¹⁷

Direct Capitalization Method (Simple Formula):

The most common application uses the property’s Net Operating Income (NOI) and divides it by a Capitalization Rate (Cap Rate).¹⁸

1. Calculate Net Operating Income (NOI):
   • Start with the Gross Potential Income (total income if fully leased).¹⁹

      

   • Subtract an allowance for Vacancy and Credit Loss to get Effective Gross Income.²⁰

      

   • Subtract all annual Operating Expenses (e.g., property taxes, insurance, utilities, maintenance—but NOT mortgage payments or income taxes).²¹

      

2. Determine the Capitalization Rate (Cap Rate): The Cap Rate is the expected rate of return for similar properties in the current market.²² It is often derived from the sale prices and NOI of comparable income-producing properties.

    

3. Calculate Value: Divide the NOI by the Cap Rate.²³ A lower cap rate generally indicates a higher property value.²⁴

    

Other sophisticated income methods, like the Discounted Cash Flow (DCF) analysis, may be used for complex or long-term investment properties.²⁵