Differences in Sales and Income Approaches

[The Warrior Monk]

I'm in commercial appraiser boot camp right now...

I've been noticing that on some assignments the differences in the sales and income approaches are extreme. So I've gone over quite a few reports to figure out why.

It seems that properties likely to be owner occupied have extreme differences between the approaches, and properties that are not likely to be owner occupied have value conclusions from these approaches that support each other.

Here are some examples:

Auto Repair Shops: Such properties are very likely to be owner occupied in this area; very divergent value conclusions between these approaches.

Village business properties: Retail, restaurants, offices, etc. May be owner or tenant occupied. Somewhat divergent values, but not as extreme as properties that will be owner occupied.

Office building, 10 or more units: Very unlikely to be owner occupied. Values support each other.

Is this phenomena typical? Or is this likely to be some local phenomena? Or am I just clueless?:new_all_coholic:

 

[Fred]

Is this phenomena typical? Or is this likely to be some local phenomena? Or am I just clueless?

David,
I’d like to take step back and ask a few questions.

Why do you think the approaches ought to match? Do you have any textbooks or journal articles saying that they are supposed to? I don't expect the approaches to match and haven't seen any literature suggsting otherwise. That said, there is a lot of force-equalizing going on. KInd of reminds me of our cost approach discussion.

Do you think a property would be worth the same amount to an investor and a user? Suppose you want to buy a box and rent it to someone (and you are capitalizing income to figure out how much to pay). Walmart likes the same box. Who is going to end up owning it? Later you are looking at another bos and capitalizaing income - and guess what - it's coming out less than when you use the box that Wal Mart bought for a comp in sales comparison. :icon_smile:

Why are you capitalizing hypothetical income for owner occupied properties? Why are you doing sales comparison on rented properties?

 

[The Warrior Monk]

Steven,

Whether you know it or not, you've implicitly answered my question.

Why do you think the approaches ought to match?

I don't. I'm just making observations, noticing a pattern, and trying to draw conclusions. In fact, I'm asking to make sure that I'm being objective and not trying to manipulate my own thought process to try and justify the difference. It comes from the scientific experimentation by quantum physicists: Does our participation in the experiment cause the results to be what we wish them to be?

KInd of reminds me of our cost approach discussion.

The cost approach discussion was very different, in that, at least in my case, I was arguing in reference to residential properties. IMHO, in the valuation of residential properties (not necessarily multifamily investment properties), all of the approaches are inbred. The Cost Approach relies on sales for the valuation of the land and obsolescence, and the GRM needs a sales price to be determined. Using data from the same pool, even when looking at it in different ways, should produce similar results. That's the reason why I believe the Cost Approach can be price predictive. The umbilical cord between the Cost and Sales Approach can't be cut.

And guess what: For proposed nonresidential buildings to be owner occupied, the cost approach is typically similar the the value concluded via the sales approach, just as in residential properties.

Just for your partial comfort: Unlike residential properties, I have only been completing the Cost Approach on proposed projects.

Do you think a property would be worth the same amount to an investor and a user?

I'm working the problem the other way around. From my observation of the data, I am concluding that the investor and owner occupant see a difference in value.

Why are you capitalizing hypothetical income for owner occupied properties?

I think I know what you are getting at here, but I'm not sure because of the wording. "Very likely to be occupied" is not the same as "Always occupied." The former implies that an investor could, but is unlikely to, buy the property. The latter implies that an investor would not buy the property. Obviously these situations would be handled differently.

Why are you doing sales comparison on rented properties?

I'm not on properties with long term leases. They're either vacant, month to month, or in one case, the ink was drying for a short-term (2-year) lease at market rent as I was inspecting .

 

[Fred]

Whether you know it or not, you've implicitly answered my question.

I know I answered, but not everyone counts Socratic questions as answers. :icon_smile:

I think I agree with what you said at the bottom of the post, but not with what you said at the top.

The cost approach discussion was very different, in that, at least in my case, I was arguing in reference to residential properties.

Would it help if I linked your references to nuclear power plants, churches, etc.? :icon_smile:

For me the discussions are inextricably linked, if not the same, because at the core is the question of whether different methods are all supposed to produce the same number and what does it mean when they do or don’t.

The shortest answer to your questions is that results vary because
1. multiple methods earned recognition because there are multiple value theories
2. user value is different from investor value

IMHO, in the valuation of residential properties (not necessarily multifamily investment properties), all of the approaches are inbred

Methods are like putty in the hands of the appraiser. They are inbred, if you inbreed them. I don’t see any inbreeding because an appraisal estimates the value of the land and estimates the value of the improved real estate. Two different properties, two different markets.

You seem to be on the right side of a line that and a lot of literature preaches something else. Your rationale seems to be driven by valuation theories. That is, you find the probable use, most probable user and then execute the method that puts a number on that valuation theory. If it is not so clear-cut because there is more than one probable use and one type of probable user, then you have to look at multiple theories and use multiple methods. On the other side of the line, appraisers seem to be driven by the idea that there is “a” number out there and if you throw every method at the problem, they will all hit that number – and getting them all to hit that number is what proves reliability. Or some of them may miss, but just sort it all out in reconciliation.

It’s funny that the same cost approach discussion, and the idea that approaches are supposed to be equal, led me to the AI text 10th ed, chapter on reconciliation. There is a stunning example that goes right to these two types of two processes. The text suggests that during reconciliation, one ought to give consideration to the intended use. :icon_eyecrazy: It then gives an example, in which there is a legal standard of value and suggests that this special standard would guide you in which of the methods should get reliance. Excuse me! But isn’t that backwards. If one starts with the intended use as a key element of identifying the problem, one can then determine - before, developing a method, not after - which method is “necessary to produce a credible appraisal” and which ones aren’t.

 

[Terrel L. Shields]

My spin on Commercial property is Sales of owner-occupied property should be the standard by which you appraise them.

Income App. is the most probable value the investor type property would bring - e. g. - apartments, strip mall rentals, etc.

Cost app is a default which gives you a number where you have a new building with no stabilized income nor new comparables.

I generally find that HBU is the 500 # gorilla that troubles all that. We are appraising a new proposed 3 bay repair shop. Flag pole lot. 5 mi. from town. I know what it will cost.....but the site is not HBU for a Repair garage. It won't rent anywhere close to the cost. it likely won't sell except as an on-going business. So what approach "works"? The short answer is none. The slightly longer answer is that the Cost App. probably can be defended better than any one of the other...I know Steve won't like that, but where is a new garage going to sell? And who wants to rent a garage that is 5 mi. from town? The adjustment in the Cost App will be to the land price which is not HBU as commercial...more like residential value.
That is the best I can do with it.

 

[The Warrior Monk]

Methods are like putty in the hands of the appraiser. They are inbred, if you inbreed them.

That's true...but it's also the way it's taught. For example, in "The Appraisal of Real Estate," 12th Ed., we have this statement right in the very first paragraph of Chapter 17 (The Sales Comparison Approach):

"Similarly, conclusions derived in the other approaches are often analyzed in the sales comparison approach to estimate the adjustments to be made to the sales prices of the comparable properties."

There obviously cannot be independence between the approaches if this is done.

At this point though, I think I'm in agreement that the investment approach to value is independent of the sales and cost approaches, provided cap rates are derived from similar investments and not sales prices, which would cause inbreeding.

Do I get my Jeter shirt now???

 

[Fred]

David,

Why are you capitalizing hypothetical income for owner occupied properties?

I think I know what you are getting at here, but I'm not sure

Hypothetical wasn’t the right word. Pro forma capitalization is a better term. Know “why” it’s necessary or not necessary to your theory of the subject property - and not just do it all the time by rote or assume it’s never relevant.

About the Jeter shirt, you can't have mine. You can have all the A-Rod shirts you want though. The Yankees have too many short stops and not enough pitchers. :icon_smile:

 

[The Warrior Monk]

David,Hypothetical wasn’t the right word. Pro forma capitalization is a better term. Know “why” it’s necessary or not necessary to your theory of the subject property - and not just do it all the time by rote or assume it’s never relevant.

I realize that...No Cost Approach for 80-year-old Village Business properties, etc. It's the boderline properties, such as the auto-repair shop mentioned here, that I'm not 100% sure of.

About the Jeter shirt, you can't have mine. You can have all the A-Rod shirts you want though. The Yankees have too many short stops and not enough pitchers. :icon_smile:

Since they have so many shortshops, maybe they should try them on the mound. After all, in a blowout game a few years back, they put Boggs out there, and he threw a perfect inning!

 

[Howard Klahr]

I am not looking to get into a protracted debate regarding the applicability of the three approaches to value but rather to try and address the original question posed by David. As valuation theory was taught to me, all three of the valuation approaches generally exhibit at a narrow range IF properly applied and all appropriate factors are considered/analyzed. This is true for 1,000 year old buildings, as well as single tenant/owner occupied facilities, and even large multi-tenant properties such as downtown high rise office building and regional malls.

There are reasons that one approach may provide greater reliability over another in a particular analysis, but that does not disqualify the validity of the other approaches to value.

In reference to the examples listed I will try to provide some potential insight as to why the trends observed appear to exist.

1) Owner Occupied Auto Repair Shops – I assume you are noticing a trend of the Sales Comparison Approach exceeding the Income Approach. The likely reason is that the reported purchase price includes some personal property/trade fixtures in addition to business value. The allocation of the purchase price should be adjusted out in the analysis performed in the Sales Comparison approach. Rental rates implicitly exclude these items and would therefore result in a lower indicated value.

In the alternative where the Sales Comparison approach is frequently below the Income Approach, are the locational characteristics or transaction terms truly equal. Often with owner occupied properties that perform well, there are a limited number of comparable sales. As a result many of the transactions reflect either poorly performing locations or a distressed sale to some degree (i.e. – estate sale, owner is retiring/relocating, etc)

2) The smaller premium exhibited by owner/user spaces such as office, restaurant and retail would possibly reflect the benefits of owner occupied space versus leased space. There are tax benefits, greater flexibility to the business and other external factors that do not exist in pure investment transactions. This is actually exhibited in residential markets to a certain degree also. In many markets with all other factors being equal, investor owned properties will tend to sell at a somewhat lower price versus those that are owner occupied. Investors tend to be less emotionally attached to the deal and base their decisions only on the numbers.

The owner user premium does not only apply to local businesses, national chains have paid premiums to obtain certain specific locations. However the number of tenants doesn’t always account for the variation. If you look to industrial properties as an example, a single tenant light manufacturing or distribution building will often reflect similar values between the approaches. This is due to the high degree of Substitutability, (any one property can easily be substituted equally fulfill the need).

I apologize for the length of the reply but I hope this is helpful to some degree

 

[Fred]

Howard,
How would one go about doing the income approach on an owner occupied auto repair property? David says in his area they are very likely to be owner occupied, so, for example, what would be the basis of establishing subject’s most probable rent?