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.
Income: based on the income the asset can produce over the life left in the asset.
Fair Market/ Market: the value agreed upon by a willing buyer and seller in a particular market.
Cost/ Replacement Cost: considers how much will it cost to replace or rebuild the property, building, with a new building.
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 bought it for?
Your lender’s perspective will be more market value oriented. A commercial property’s value is directly correlated to the net operating income; income minus operating expense. 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. .
The insurance company’s perspective is based on the cost to replace the building you own. 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. If the building is damaged or destroyed, your insurance company will compare the limit on your policy to the amount needed. Assuming there are no issues, they will pay for the building to be rebuilt, restoring your income and the asset the bank lent against.
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.
And the insurance company wants replacement cost value.
If a buyer gets a good deal this could be based on the economic potential due to a weak operator or the opportunity to develop the property into something greater. In either case, there is no reason the acquisition price should reflect the cost to replace the property.
Likewise, market value could be driven by the location. If the ground is valuable, it could be the driving force behind the value that the bank lends against.
If the structure is small, and simple, the replacement cost could be very small in relation to the market value determined by the bank.
The insurance company is not concerned with the income nor market value. It’s promise to the insured is to replace the property.
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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