Is the Income Approach always viable?

[Anonymous]

I had a small discussion with a fellow recently who avers you must do the income approach on all commercial property. I argue the income approach on owner occupied buildings in a small market is indefensible, therefore pointless.

The intricacies of any small town (say pop. 2000) market suggest leaving that town is an iffy way to appraise a commercial building, but the vast majority of buildings sold in town were usually owner occupied, and the few that are not owner occupied do not always provide a good handle upon market rents.

I suggested that unless rent data are readily available, the income approach should be excluded in owner-occupied commercial buildings like most real estate offices, insurance offices, hardwares, law offices, typical small town businesses. And convenience stores usually are marketed based upon gross fuel sales..i.e.-a business interest. Restaurants have equipment and, usually, a franchise or goodwill contribution, etc. You may not have 5 sales over a 3 year period in such a small town.

Similar markets yield similar results, but going into a larger town (aka market) changes the dynamics. Location then dominates the scene and makes the income approach even less reliable.

How do you commercial appraisers handle these single tenant commercial properties? Any weight given the income approach? And how are you extracting a cap rate from comparable sales without a rent history. "guessing" a rent does not appeal to me much.

 

[Steve Owen]

You bring up some interesting points. However, I wonder what you would do in this small town if there was no income data and also no sales data; a possibility that doesn't seem too far fetched. Would you rely on the Cost Approach exclusively? I think not. My thought on the matter is that you would go to other nearby small towns for the market data. In other words, expand your search geographically. If that doesn't work, then getting what data you can from larger markets (and possibly smaller markets) might be the next best solution. We used to skip the Sales Comparison Approach as not applicable quite often. Then, through talking to other appraisers, instructors, and members of the appraiser's commission, I came to the conclusion that it is better to use poor data than to not do the approach at all. Of course, in such cases, I give the Sales Comparison Approach little weight. There might possibly be a case where the Income Approach is not applicable, but I haven't run into it yet.

 

[Mountain Man]

Ask the lender, Please can we get by with a limited?? :lol: Or beg for data from other small towns all over the region. Sometimes that is about the best you can do. I run into the same problems.

 

[Steve Owen]

One important point. If there really isn't any data and the approach is not applicable, then it is not a limited appraisal.

 

[Anonymous]

Limiting the appraisal does not solve the problem. I am OK with the Cost Approach...in fact I weight it on perhaps 50% of my farm appraisals, and 10% or so of the commercial ones. Abstracting the sales into meaningful comparisons to cost will allow you to develop a sense of costing that replicates sales comparables. After all, whats the difference in estimating depreciation in the cost approach, or applying a locational adjustment?, functional utility adjustment? etc. Without costing out the comparables how do you estimate Functional utility for example? You cannot except PFA (pull from Air)

I prefer to go back in time, but stay in the market. I think a 6 year old sale is easier to adjust for time than a location adjustment is to make...again..if you lack data in the small town, how do you know another small town has similar market?

One of our local small towns was recently mentioned in Real Estate news magazine. Seems Lowell, Arkansas has the highest growth rate in the nation, going from 200 or so to over 2000 in less than 10 years. They has some commercial property now going for $10/SF. On the other side of the county, Gentry commands a whooping $2/SF for same kinds of businesses (Taste Freez, Conv. Store, car wash.)

Small commercial property buyers look for one of two things. Owner-Op want to know if their future business will cash flow the mortgage or they do a cost like analysis. Site would cost me X, new building Y per SF, or existing building will cost Z and I have to spend Q to modify it to my needs. From sales over the years, I find land values seem to increase, but old buildings less land, tend to fetch only $15-30 per SF regardless age or size. And if the marketplace is considering cost, then the appraisers should consider cost. What the marketplace is not considering is how much are rents.

 

[Rlong]

I GENERALLY do the income approach even if the type of property is usually or almost always owner opperated. I will generally weight it so in my final analysis. But when they ask and pay for a "complete" I feel like any data is better than none, as someone said previously. I also feel like it gives the bank an idea where they would be at if they end up sitting on it for a year or so. As has been stated by others I will go to other "Similar" communities, SIMILAR MARKET being the key, or back "X" number of years if I have to.

That all being said I have done appraisals and stated the income approach is not a significantly valid indicator, blah blah.

 

[xmrdfghap]

I have done commercial reports that do not use the income approach......and when I do that I provide a very detailed explanation as to why one is not used. However, if the owner is willing, I have used the books of the current business to provide a projected reasonable rent....one that would be supported by the income generated by the business inhabiting the building. I know, this information is being evaluated by the LO to see if the mortgage is supportable by the income, but I like to see if the business, managed as it is today, could be run by another party if for some reason (other than business failure....things like death, incapacitation, etc) the property becomes REO.

 

[Damon Pedersen]

This is an intersting topic for me. I too live and appraise in many small towns, and also a few larger ones. However, the majority of my work is in small communities, less than 5,000 people and in rural areas. The INCOME approach always seems debatable to me. When is it applicable, when it is not? Who knows. The thing I always question in my head is whether a review appraiser (peer) would consider it applicable if I did not perform it in my report.

As pertained to commercial properties in small communities, I agree that there is rarely any sales to support a "market" derived rental data. We have old buildings with main floor level size of 7,500 square feet and old apartment spaces above selling for $25,000 per building. The apartment space is old and not used typically so no income there. The building becomes owner occupied for a small flower shop or whatever and then sells several years later for basically the same price. So, in a community where there are no investment retail building sales, I do not feel the INCOME approach is applicable. Cost approach on turn of the century buildings such as these is somewhat reliable at best. The most weight is given to the sales comparison approach. Commercial properties I typically go back up to 5 years and include as many similar sales as I have on file. Just because an appraiser doesn't perform the INCOME approach doesnt mean the appraiser is too lazy to go out and get the data, it just means that it may not be applicable and that is basically the only thing we need to worry about. Is it applicable? Is it what your peers would (or would not) consider applicable in a review?

I wouldn't mind using similar sales from area communities for the sales comparison approach, but these communities don't have rental data available either, so the question is how far away should you go to get the data before it gets to be too far. I like to stay within the community or surrounding communities say within 20 miles.

I wouldn't go so far as to guess a rental rate and extract data based on that guess. If it isn't available, we shouldn't have to hypothetically make it up just to bulk up the report.

On another note, I also sometimes question the INCOME approach on small farm acreages. There are many times where I indicate that i feel it is not applicable and explain why in the report. I just did a small farm acreage that was 20 acres in size with 10 acres tillable and 10 acres buidling site. Home was an older 2 story which has been updated and had a value of around $60,000. Land had a value of $2,700 per acre. Building value was minimal except for some storage sheds. The owner has around 50 feeder cattle in some small yards and no other livestock. The value I came up with was around $150,000. Now, in this market, a house similar to his may rent for $250 a month and his tillable land would rent for $120/year. Building rental would be minimal, say $200 a month. Feeding income from cattle or hogs I feel would not apply do to being such a small operation with high labor costs, so I don't feel any income can be derived from animal production.

So we have a total annual income of $3,000 for the house and $2,400 for the buildings and another $1,200 for the tillable acres. After expenses, I don't feel that the the small income from this property is applicable to capitalize out. Am I thinking wrong or would some of you swear by the bible that the income approach would be applicable in this situation. I don't think it is. Please tell me if I am wrong. Keep in mind taxes are around $1,000 and insurance I would assume to be in the $600 per year range. Maintenance on the older outbuildings would also be high. Give me your thoughts on this.

Damon

 

[Steve Owen]

I agree with your thoughts as far as farm properties go. In or near an MSA like I am in in Southwest Missouri these properties often have a much higher value, as can be proven with comparable sales data, than farm income would ever support.

On the other hand, if you are in a small town in this same kind of area, comparable rental data from larger towns is often okay to use. The question in my mind is not "how large is the town?" but rather "where is the market." Webb City, a fast growing town of only about 10,000 is the same as Joplin (45,000+) if the property is on business 71. It's the same cars going by, the same customer base, and the same buyers. I don't think elimination of the Income Approach is supportable as a complete appraisal in that situation.

 

[Damon Pedersen]

I agree with you. If an appraiser is eliminating the Income Appraoch to simply make the report easier on the appraiser's end I would not call it a Complete Appraisal. If it is being eliminated due to lack of data or lack of reliability then I would still say it is a Complete Appraisal.

Damon