Real Estate Appraisal Methods: The Three Approaches to Property Valuation
By Ashita Chandra, AACI, P.App — Director of Valuations
There are three real estate appraisal methods: the income approach, the direct comparison approach and the cost approach. Every appraisal uses one or more of them, and the appraiser must consider each one that applies to the property. For a leased commercial building the income approach usually leads; for a house, a condominium or vacant land, direct comparison; for a new or special-purpose building, the cost approach. The indications are reconciled by judgment into one final value, never averaged.
The income approach
What it measures. What an investor would pay for the income the property produces. It leads for leased office, retail, industrial and multi-unit buildings, because that is how buyers of those buildings price them.
The arithmetic. Market rent for the space, less a vacancy and collection allowance, less the operating costs the owner bears (realty taxes, insurance, maintenance, management and other non-recoverable costs), gives net operating income. Net operating income divided by a capitalisation rate gives value:
Value = Net operating income ÷ Capitalisation rate
Where the capitalisation rate comes from. It is not chosen; it is extracted from recent sales of comparable income properties (sale price against the net income at the time of sale) and adjusted for the subject's tenant quality, lease term, age and location. A lower rate means buyers accept less income per dollar and pay more; a higher rate means the reverse. Half a point on the rate moves the value by roughly 7 to 8 per cent, which is why the evidence for the rate matters more than the arithmetic.
Discounted cash flow. For a multi-tenant building with leases expiring on different dates, or a property with a known change ahead (a vacancy to fill, a rent step, a redevelopment), the appraiser projects each year's cash flow over a holding period, usually ten years, and discounts those flows and the resale value back to today. It is the income approach with the timing made explicit, not a fourth method.
When it leads. Any property bought for its rent. Its limit. It is only as good as the rent and cost evidence behind it. Above-market leases, short terms, tenant risk and deferred maintenance all have to be reflected, or the number is wrong in a way the arithmetic will not show.
The direct comparison approach
What it measures. What similar properties recently sold for, adjusted for the differences. It rests on the principle of substitution: no buyer pays more for a property than the cost of an equally desirable one.
How it is done. The appraiser selects recent sales of comparable properties, expresses each in the unit buyers use (price per square foot of building, per unit for apartment buildings, per acre or per buildable square foot for land) and adjusts for date of sale, location, size, age and condition, zoning and lease terms. The adjusted sales indicate a range, and the appraiser picks the point in it that the subject's own characteristics support.
When it leads. Houses and condominiums, vacant and development land, farms, owner-occupied buildings, and any commercial property in a market with enough recent, similar sales. For leased commercial buildings it is the check on the income approach.
Its limit. Commercial sales are fewer and less alike than house sales. Two industrial buildings of the same size can sell a year apart at prices 30 per cent apart because of clear height, loading, lease terms or the buyer's use. The adjustments, and the evidence for them, are the work.
The cost approach
What it measures. What it would cost to replace the property today: the land value, plus the cost to build the improvements new, less the depreciation they have suffered since.
How it is done. Land value by direct comparison with land sales. Replacement cost new from published cost manuals and local construction evidence. Depreciation in three parts: physical (age and wear), functional (an outdated layout, a ceiling too low for modern use) and external (something outside the property, such as a road closure or an oversupplied market).
Value = Land value + Replacement cost new − Depreciation
When it leads. New construction, where cost and value are close. Special-purpose properties that rarely sell and produce no rent of their own: churches, schools, arenas, process plants. Insurance appraisals, which need the replacement cost only, without the land.
Its limit. Depreciation on an older building is an estimate, and a large one. Past about fifteen years of age the cost approach usually supports the other two rather than leading.
Worked example: one building, three approaches
The numbers are illustrative and show the arithmetic only; they are not a quoted rate or value for any property or market.
A 12,000 square foot single-tenant industrial building, leased, in a market where comparable buildings sell at $215 to $240 per square foot.
Income approach. Gross rent less a vacancy allowance and the operating costs the landlord bears gives a net operating income of $180,000 a year. Comparable sales indicate a capitalisation rate of 6.5%. $180,000 ÷ 0.065 = $2,769,000, rounded to $2,770,000.
Direct comparison approach. 12,000 sq ft at $215 to $240 per square foot indicates $2,580,000 to $2,880,000. The subject is newer than two of the four sales and has better truck access than one, which puts it in the upper half of the range: $2,750,000.
Cost approach. Land, by comparison with industrial land sales, $850,000. Replacement cost new, 12,000 sq ft at $200, $2,400,000. The building is 18 years old; physical depreciation at 25 per cent is $600,000, with no functional or external depreciation found. $850,000 + $2,400,000 − $600,000 = $2,650,000.
Reconciliation. Three indications: $2,770,000, $2,750,000 and $2,650,000. The building is leased, so the income approach carries the most weight. The direct comparison result sits within $20,000 of it and supports it. The cost approach is lower because the depreciation estimate on an 18-year-old building is the least reliable number in the report, so it carries the least weight. Final estimate of value: $2,750,000. Not the average ($2,723,000) and not the highest: the figure the strongest evidence supports.
The arithmetic behind the income approach is in our cap rate calculator, if you want to try it with your own numbers.
Which approach leads for which property
| Property | Leads | Supports | Why |
|---|---|---|---|
| Leased office, retail or industrial building | Income | Direct comparison | Bought for its rent |
| Owner-occupied industrial or commercial building | Direct comparison | Income, at market rent | No lease in place; buyers price per square foot |
| Multi-unit residential, five or more units | Income | Direct comparison per unit | Bought for its rent; per-unit sales test the result |
| Vacant and development land | Direct comparison per acre or per buildable sq ft | Residual: land value left after development costs | No income, no building |
| Farms | Direct comparison per acre | Income, rent per acre | Sales set the price; soil, drainage and buildings adjust it |
| New construction | Cost | Income or direct comparison, as completed | Cost and value are close at completion |
| Special-purpose: church, school, arena, plant | Cost | Direct comparison where any sales exist | Rarely sold, no market rent |
| Insurance appraisal | Cost, replacement cost only, no land | None | Coverage needs the rebuild cost, not market value |
| House or condominium | Direct comparison | Cost, for new homes | Residential work, outside Aion's practice |
What is not an appraisal method
An MPAC assessment is mass appraisal: a model applied to thousands of properties at once, as of a past date. It is a tax figure, not a market value for your property today. A broker's opinion of value is a marketing estimate without the independence or the standards; lenders do not accept it. Online estimates have no site visit, no rent roll and no comparable analysis. Rules of thumb (price per door, a gross rent multiplier) are shorthand investors use to screen, not evidence of value.
Who applies these methods in Ontario
An appraiser holding the Appraisal Institute of Canada's AACI designation, for any property type; the CRA designation covers residential property of up to four units. CUSPAP, the Canadian standard every Institute member must follow, requires the appraiser to consider each approach that applies and to explain in the report why any usual approach was not used. Every Aion report is signed by an AACI-designated appraiser and reviewed by a second one before it is signed. What the designation means is in our guide to the AACI designation; what the report contains is on the commercial property valuation page, and how the process runs is on the how it works page.
Real estate appraisal methods FAQ
Which real estate appraisal method is most accurate?
The one with the best evidence for that property. For a leased building, the income approach, because its inputs (rent, costs, capitalisation rate) come from the market its buyers are in. For a house or vacant land, direct comparison. Accuracy comes from the evidence, not the formula, which is why the report shows every approach that applies and reconciles them.
What are the three approaches to value?
The income approach (net operating income divided by a capitalisation rate), the direct comparison approach (adjusted recent sales of similar properties) and the cost approach (land value plus replacement cost new, less depreciation).
How do you value a commercial property?
An AACI-designated appraiser applies the approaches that fit the property: the income approach for leased, income-producing buildings, direct comparison where there are comparable sales, and the cost approach for new or special-purpose buildings. The indications are reconciled into one final value.
What is a capitalisation rate and where does it come from?
The ratio of a property's net operating income to its sale price, taken from recent sales of comparable income properties. A building that sold for $2,000,000 with net income of $130,000 shows a 6.5% rate. The appraiser applies a rate drawn from several such sales to the subject's income.
Does an appraiser have to use all three approaches?
No. CUSPAP requires the appraiser to consider each approach, apply the ones that are relevant, and explain in the report why any usual approach was left out. A leased office building rarely needs the cost approach; vacant land never needs the income approach.
Do the three approaches give the same value?
Rarely. Each measures value from a different angle, so they bracket it. The appraiser weights them by the reliability of their evidence and settles on a final figure; it is not an average.
Is discounted cash flow a different method?
No. It is the income approach with the timing of the income made explicit: each year's cash flow over a holding period, plus the resale, discounted to today. It is used for multi-tenant buildings and for properties with a known change ahead.
What is the difference between valuing commercial real estate and a home?
A home is valued by direct comparison with recent sales. Commercial real estate is usually valued on the income it produces, using market rent, vacancy, operating costs and a capitalisation rate drawn from comparable sales, with sales as the check.
AACI, P.App
Ashita Chandra is an AACI-designated appraiser and Director of Valuations at Aion Appraisals & Consulting, preparing commercial property appraisals across Ontario.
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