This is the fifth in an 11-part series of understanding the key ingredients in all successful real estate transactions.
Perhaps this question pales in comparison to philosophical quotes of Socrates like; the unexamined life is not worth living, but for a moment it surprises us enough to make us pause and consider our thoughts. Are we right in our assumptions, have we thought it through, are our research results sufficient to make the correct decision? Or are our beliefs based on myths, or something our family members told us with great emphasis and so we believe without further inspection?
Cognitive illusion enters the arena when a buyer and seller begin the process of negotiating the purchase or sale of almost anything. The seller believes the asking price is right while the buyer perceives they know better and determines the price is much too high.
In commercial real estate, the traits of buyers and sellers are similar to any other negotiated purchase only the scale or size of the dollar transaction is likely greater. So how and what is the process to determine value and how does the commercial broker assist in calculating it?
In real estate there are three basic approaches in determining property values, the Sales Comparison Approach, the Income Capitalization Approach and the Cost Approach. Normally only two of the three approaches to value are used in an analysis. Partial definitions are as follows:
Sales Comparison Approach—A comparative approach to value considers the sales of similar or substitute properties and related market data and establishes a value estimate by processes involving comparison. In general, a property being valued (subject property) is compared with sales of similar properties that have been transacted in the open market. Listings and offerings may also be considered.
Income Capitalization Approach—A set of procedures which a person derives a value indication for an income-producing property by converting its anticipated or future benefits of ownership (cash flows and reversion) into property value.
Cost Approach—The cost approach establishes the value of real property by estimating the cost of acquiring land and building new property with equal utility or adapting an old property to the same use with no undue cost due to delay. For older properties, the cost approach develops an estimate of depreciation including items of physical deterioration and functional obsolescence.
The person determining value may also want to research related market data such as examining the supply and demand of existing buildings (see Hope Is Not a Strategy) or research planned projects in process that may affect the sale or leasing of the subject property. Additional considerations are what are current market conditions? Is it a good time in the real estate cycle to sell, buy or hold? Is financing readily available and at attractive interest rates? What do future conditions appear to be for this product type? Lastly, what is the geographic market area for this property type?
Your real estate professional needs to be proficient in analysis of this type. Getting to the right price is of utmost importance. Long term no one benefits from overpriced properties being offered in the market place. The lost opportunity of use of the sales proceeds, lost time, carry costs of vacant property, and other issues can have serious financial consequences. When the analysis and related studies are complete, you can rest assured that what you believe is true.