How to Value Commercial Real Estate Using the Replacement Method
There are various ways to value commercial real estate based on the current and projected income of a property. Methods such as income capitalization (applying a cap rate) and discounted cash flow rely heavily on the financial aspects of a property’s performance. There are, however, a few other methods used to value commercial properties, including the size of a property (price per square foot comparisons) and one that uses the estimated cost of replacing the property with a new property (cost approach or replacement method).
Understanding the Cost Approach to Commercial Real Estate Valuation
What is the Cost Approach? According to the Appraisal Institute:
“The cost approach is based on the understanding that market participants relate value to cost. In the cost approach, the value of a property is derived by adding the estimated value of the land to the current cost of constructing a reproduction or replacement for the improvements and then subtracting the amount of depreciation in the structures from all causes. Entrepreneurial profit and/or incentive may be included in the value indication.”
There are many accounting nuances associated with determining the replacement cost that we won’t cover in this article, but the basic formula for understanding the value of a property using the cost approach is:
Property Value = Land Value + (Building cost – depreciation)
The definition above also mentions two separate types of cost approach valuation, reproduction and replacement. Descriptions of each are below, but in this article we’ll ignore the subtle differences between them and discuss the two methods as a similar concept, referred to from here on as the “replacement method” or the “cost approach” interchangeably.
This is the cost of rebuilding an exact replica of the existing structure using the same materials, construction methods, condition, etc.
The cost of rebuilding the structure with new materials, construction methods, and design.
In other words, the replacement method of valuation determines how much it would cost to rebuild the building and ignores any income generating potential the property might possess. While the replacement cost of a property is used heavily in the insurance industry to determine insurance coverage amounts, this article will focus on the market value aspect of the replacement cost method and how it compares with other valuation methods.
Determining the Replacement Cost Valuation
Much the same way that real estate professionals use sales of comparable properties to obtain current market cap rates and price per square foot/price per unit, the cost of replacing a property can be obtained by reviewing the cost of constructing a similar property. Analysts should also consult cost manuals, estimators, and others familiar with the construction and development process in order to verify and refine their estimates of cost.
We can examine the components of the replacement cost method using the formula from above:
Property Value = Land Value + (Building cost – depreciation)
The land value component of the formula is straightforward and can be found by comparing the subject property’s land to similar pieces of land. The building cost and depreciation components are more complex, however, and consist of different pricing methods to determine the cost of the building and different types of depreciation to determine the depreciation component. More formal definitions should be consulted if you’re interested in the details of the cost and depreciation components.
Economic Indications of the Cost Approach
Ideally, the outcome from the different approaches to valuation would all fall within a narrow valuation range. In a stable market, this is often the case. However, as market conditions change, the cost of construction and the value placed on streams of income could change at different rates, creating a divergence in the different methods of valuation. As we’ve unfortunately experienced over the past twenty years, the real estate market can rise rapidly and fall even faster. This fact often creates disparities in the relationship between market value based on income approaches and value based on the cost of constructing a property.
In a strong real estate market where capitalization rates are low, the cost of constructing a new property is often below that of the value of the property based on the income capitalization approach. Alternatively, during periods when the real estate market is struggling, the cost of constructing a property could be more than the value of that property based on the income capitalization or discounted cash flow methods to valuation.
While this relationship theoretically makes sense, it’s often much more difficult in practice to benefit from arbitrage opportunities from the disparity in cost and income valuation approaches. Not included in the cost approach is the time and effort that must be expended to develop the property or the likelihood that market conditions will likely be different by the time the new property is completed than they are at the time of analysis.
Advantages of the Cost Approach
In the next section we’ll discuss some of the challenges associated with using the cost approach to determine market valuation, but there are some use cases where the cost approach could be a better choice than other methods. Properties with special or unique uses such as churches or funeral homes are difficult to value based on their income-generating potential. Additionally, there are sometimes situations in which there are no good comparable properties in the subject area. The cost approach could be useful in such situations.
Disadvantages of the Cost Approach
The cost/replacement method is one of the three major methods of commercial real estate valuation as defined by the Appraisal Institute. Because commercial properties are primarily valued by investors on their ability to generate income, methods such as income capitalization and discounted cash flow are relied upon more heavily than the replacement cost approach.
In addition, the cost of replacing a property ignores the changes in income that a property could experience. For example, if an office building executes a lease with a major, high-credit tenant, the value of the income stream would most likely increase significantly (assuming stable market conditions). This change in value would happen almost instantaneously and would be based solely on the financial performance of the property. The cost approach, however, would not consider the increase in value from the new lease and would underestimate the market value of the property.
In practice, investment decisions are rarely made based on the cost approach to valuation. It simply does not capture the financial interests in the property or the long-term performance of a property. It’s always good to use the cost approach as a sanity check, but investors should lean more on the income capitalization approach for snapshot valuations or the discounted cash flow valuation method to better understand the long-term potential of the property.
About the Author
Josh Panknin is a Visiting Assistant Professor of Real Estate at New York University’s Schack Institute of Real Estate and an adjunct professor in the school of engineering at Columbia University. Prior to academics, Josh was Head of Credit Modeling and Analytics at Deutsche Bank’s secondary CMBS trading desk where he helped develop and implement automated models for valuing CMBS loans and bonds. He also spent time at the Ackman-Ziff Real Estate Group and in various other roles in research, acquisitions, and redevelopment. Josh has a master’s degree in finance from San Diego State University and a master’s degree in real estate finance from New York University’s Schack Institute of Real Estate.