## Residual Techniques When Evaluating Real Estate

Residual techniques in commercial real estate valuation are sometimes used to value a property, but these residual techniques are also often misunderstood. The income capitalization approach to valuation utilizes a cap rate that represents the value created by all of the real property. It incorporates the capitalization of income from both the underlying land and the improvements built upon the land. There are, however, ways to estimate the value of a property when one of the components of total value is known and the other component is estimated.

These methods are known as residual techniques and can be used to estimate property value when either the value of the land or the value of the improvements is known. In this article, we’ll walk through several examples that will show you how the residual technique is used in commercial real estate valuation.

### Land Residual Technique Using Direct Capitalization

The land residual technique using direct capitalization was developed in order to evaluate the highest and best use for a particular piece of land. According to this technique, if the proposed use of the property is its highest and best use, the value of the building should equal the cost of construction. The value of the building is based on the construction costs.

For example, consider a problem where the construction costs are known as well as the market capitalization rates for land and improvements. The land capitalization rate is 9.5%, and the improvements capitalization rate is 10%. The cost of constructing the improvements is \$1,400,000. Multiplying the value of the improvements by the appropriate capitalization rate suggests that the improvements are responsible for generating \$140,000 in annual income. If the property generates \$200,000 in annual net operating income (NOI), the remaining \$60,000 is attributed to the land. Then, the value of the land can be estimated by considering the following:

Land Value = Cash flow generated by land / Land capitalization rate

Land Value = \$60,000 / .095

Land Value = \$631,579

Finally, the total property value is the sum of the land value and the improvements value. So, the total property value is \$2,031,579, which is the sum of the \$1,400,000 improvements value and the \$631,579 land value.

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### Building Residual Technique Using Direct Capitalization

On the other hand, there may be a case where the underlying land value is known but the improvements value is not. Suppose market estimates indicate that the land capitalization rate is 9.5% and the improvements capitalization rate is 10%. The land value is \$450,000. Multiplying the land value by the land capitalization rate indicates that the underlying land can generate \$42,750 of operating income annually. If the property has annual net operating income of \$200,000, that means the remaining \$157,250 in annual NOI can be attributed to the improvements. Dividing this cash flow by the building capitalization rate provides the estimate of the building value.

Building Value = Cash flow generated by building /Building capitalization rate

Building Value = \$157,250 / .010

Building Value = \$1,572,500

Adding together the building value and the land value provides an estimate of the total property value. So, a land value of \$450,000 and building value of \$1,572,500 would create a total property valued at \$2,022,500.

### Land Residual Technique Using Cost and Sales Comparison

The major drawback to using the above direct capitalization method to extract the land value is that it requires knowledge of both the land capitalization rate and the improvements capitalization rate. In urban, highly developed areas, there may not be enough unimproved land sales to accurately establish a market land capitalization rate. In reality, it is typically a blended capitalization rate that is observed in the market. Market value is a function of cash flows generated by the land and improvements together, and the capitalization rate reflects that combined value. To account for this, there is another method commonly used that does not require individual capitalization rates. It is the land residual technique using cost and sales comparison.

The first step of this technique involves finding the market value of the total property (both the land and improvements). Typically, either the sales comparison or income capitalization approach is used to find the property value. Next, the cost approach is applied in order to find the depreciated value of the improvements. Finally, subtracting the depreciated value of the improvements from the total property value leaves the market value of the land.

For example, suppose that when using the sales comparison approach, a property is valued at \$1,400,000. Using the cost approach, replacement cost new of the improvements is calculated to be \$1,260,000. Using straight-line depreciation over 31.5 years yields a total accumulated depreciation of \$320,000 over eight years. Therefore, the depreciated value of the improvements is \$940,000, which is the difference between the replacement cost new of the improvements and the accumulated depreciation. The residual value of \$460,000 can be attributed to the land.

 Property Value 1,400,000 Improvements Value New 1,260,000 Accumulated Depreciation 320,000 Depreciated Improvements Value 940,000 Land Value 460,000

### Building Residual Technique Using Cost and Sales Comparison

The value of the improvements can also be extracted from the total property value using a similar technique. The income capitalization or sales comparison techniques can again be used to find the market value of the total property (land and improvements). Next, find the market value of the land using the sales comparison approach with recently sold, unimproved lots. Subtracting the land value from the total property value gives an estimate of the building value. Using this technique to find the building value is helpful when estimating depreciation is difficult or adequate data on developer profit and overhead is not available.

For example, suppose the income valuation approach suggests that the subject property’s market value is \$2,200,000. Sales of unimproved lots in the area indicate that the underlying land value is estimated to be \$250,000. The difference between the total property market value and the land value is the depreciated value of the improvements.

 Property Value 2,200,000 Land Value 250,000 Depreciated building Value 1,950,000

Therefore, the depreciated building value is \$1,950,000. It is important to note that this estimates the value of the improvements after accounting for accumulated depreciation and is not replacement cost new.

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### Conclusion

In this article, we discussed land residual techniques and building residual techniques commonly used in commercial real estate valuation. We started with land and building residual techniques based on both land and building capitalization rates. The drawback to this method is that cap rate data is usually not detailed enough to be split between land and buildings in many areas. We then discussed land and building residual techniques using the cost approach and the sales comparison approach. The benefit of this method is that it allows you to use a blended cap rate for both the land and the building, which is what is typically observed in the market.

## Sales Comparison Approach When Evaluating Real Estate

The sales comparison approach is a popular and common valuation methodology for real estate. Yet, there are many nuances to the sales comparison approach for commercial real estate that are misunderstood. The sales comparison approach can be particularly helpful when a property does not generate lease income, or that information is not available. In this article we’ll discuss the sales comparison approach for real estate in depth.

### What is the Sales Comparison Approach to Real Estate Valuation?

The sales comparison approach estimates market value for a property using recent sales data from other similar properties. The sales comparison approach requires that there is an active market for similar properties. In addition, local market conditions, as well as national economic conditions, should be stable in order to reasonably support the valuation using comparable property sales. The sales comparison approach considers the selling prices of similar, recently sold properties. Those sales prices are adjusted to reflect the time, conditions, and differences between the comparable properties and the subject property. The result of the adjustments is a subject value estimate.

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### Sales Comparison Approach: Adjustment Factors

Ideally, the comparable sales should be as close to the present time as possible and be nearly identical to the subject property. These conditions minimize the need for adjustments. In practice, there can be many factors that can cause price differences between two comparable properties. These differences can fall into nine categories.

• Ownership Interest – Differences in ownership interest result in differences in value. A property is valued differently if the owner has a fee simple interest compared to a leased fee interest. Therefore, a valuation must adjust for differences in ownership interest.
• Cash Equivalency – In some cases, a buyer pays a higher sales price for a property in exchange for below market rate financing. So, the sales price must be adjusted downward to account for that premium.
• Conditions of Sale – A value estimate should consider an arm’s length transaction between two unrelated parties. Adjustments are required for comparable sales that were forced sales and those in which the buyer and seller were in some way related or affiliated.
• Market Conditions – Depending on the local economy and market for real estate, prices may trend in either a positive or negative direction over time. Unless the comparable sale took place in the last week, chances are that the market conditions have changed a bit. It can be more difficult to accurately make these market adjustments when there are large movements in price during a short period of time.
• Locational Characteristics – Location is a key element in real estate valuation because an individual property’s value is dependent upon the properties and area that surround it. Differences in location-specific factors like transportation, traffic patterns, school quality, shopping availability, and access to adequate utilities between a comparable property and the subject property require an adjustment to the sales price.
• Physical Characteristics – Physical characteristics make up the most obvious differences between two comparable properties. As a result, adjustments are necessary for physical differences such as age, condition, quality, design, and special equipment or features.
• Economic Characteristics – Aside from physical, locational, and transactional differences in properties, there may be economic differences that affect the expected cash flows. For example, higher operating expenses or management expenses reduce the net operating income of the property. In turn, lower net operating income results in a lower valuation. If the operating and management efficiency of a comparable property is not similar to the subject property, an adjustment is necessary. In addition, differences in tenant mix, lease terms, and lease concessions all directly impact expected net operating income and therefore property value. These differences are directly measured when using the income approach to valuation, but they cannot be ignored in the sales comparison approach either.
• Use – A key component of real estate appraisal is valuing a property at its highest and best use. In the case where either the comparable property or subject property’s existing use is not its highest and best use, there must be an adjustment to the value.
• Non-realty Components of Value – Sometimes the sale price of a property not only reflects the land and improvements but also non-realty components. For example, the sale may include furnishings or other items of personal property, intellectual property, or ongoing business value. These non-realty components of the sales price must be extracted in order to accurately establish a value estimate using the sales comparison approach.

### Sales Comparison Approach: Making Adjustments to Comparable Properties

The goal of the adjustment process is to make the comparable property look more like the subject property. So, the price is adjusted to account for valuation differences due to each of the factors from the previous section. Adjustments can be made as a direct dollar amount or a percent of overall value. Factors such as ownership interests, non-realty components of value, and cash equivalency are easier to estimate as a direct dollar amount. Other factors, such as market conditions, location, economics, and physical characteristics may be more accurately represented as percentage adjustments in value. Consider direct dollar adjustments first and then incorporate percentage adjustments. Who buys houses in Hialeah

Determining the actual amount of the price adjustment is a subjective process. Most of the time, there is not a single correct answer. As a result, appraisers often present a value estimate in range rather than as a single number. The estimate of the adjustment can come from a data source publishing value estimates, personal knowledge of and experience in a given market, or using quantitative analysis of past sales.

### Estimating Subject Value Using The Sales Comparison Approach

After completing the process of making adjustments to comparable prices, the result is a market estimate that can be applied to the subject property. The subject value can be estimated using a market estimate of dollars per square foot or dollars per unit as well as a market multiplier. Examples of market multipliers include the Potential Gross Income Multiplier (PGIM), Effective Gross Income Multiplier (EGIM), Net Income Multiplier (NIM), or cap rate.

### Sales Comparison Approach Example

Suppose the subject property we are evaluating is a new 24,000 sqft office property. Market rent for this area is \$15/sqft, average operating expenses are \$4.10/sqft, and average vacancy is 6%. There have been three similar properties that have sold during the last 18 months.

 Comp 1 Comp 2 Comp 3 Sales Price \$2,675,000 \$4,200,000 \$1,950,000 Time of Sale 5 months ago 8 months ago 18 months ago Age 5 years 3 years 5 years Gross building area (SQFT) 26,500 46,200 22,300 PGI \$344,000 \$592,000 \$227,000 Vacancy 5% 6% 0% EGI \$326,800 \$556,500 \$227,000 Operating Expenses \$99,000 \$172,500 \$72,000 NOI \$227,800 \$384,000 \$155,000 Price/sqft \$100.94 \$90.91 \$87.44 PGIM 7.78 7.09 8.59 EGIM 8.19 7.55 8.59 Cap Rate 0.085 0.091 0.079

The market values in this area have been steadily increasing by about 1% every quarter for the past two years. So, the comparables must all be adjusted upward since they would sell for a higher price today. While properties constructed in the past five years are nearly new, a brand new property would actually sell for a 4% premium. The prices of the comparables must be adjusted upward by 4% to match the new subject property. Comparable 1 is built with above-average construction materials. The subject, along with comparables 2 and 3, is of average construction quality. Therefore, comparable 1 must be adjusted downward to consider how it would be valued if it were constructed of average quality.

 Comp 1 Comp 2 Comp 3 Price/sqft 100.94 90.91 \$87.44 Market conditions 2% 3% 6% Age 4% 4% 4% Quality -2% 0% 0% Total Adjustments 4% 7% 10% Adjusted Price/sqft 104.98 97.27 96.18 Adjusted value 2,781,970 4,493,874 2,144,814 Adjusted PGIM 8.09 7.59 9.45 Adjusted EGIM 8.51 8.08 9.45 Adjusted Cap Rate 0.082 0.085 0.072

Applying the total adjustments to the original price per square foot for each property results in an adjusted price per square foot and adjusted overall sales price for each comparable. The adjusted PGIM, EGIM, and cap rate result from re-calculating the multiples with the adjusted prices. These adjusted market multiples can then be applied to the subject property in order to estimate its market value using the sales comparison approach. The current market analysis resulted in the following proforma cash flow statement for the subject property next year.

 Subject Proforma PGI 360,000 Vacancy 21,600 EGI 338,400 Operating Expense 98,400 NOI 240,000

A simple average of three comparables provides an estimate of the market value for each multiple. That multiple can then be applied to the subject property to find the subject value estimate. To do this simply multiply the PGIM by the subject’s expected PGI. Then, multiply the EGIM by the subject’s expected EGI. Finally, divide the subject’s expected NOI by the market cap rate.

 Market Indicator Estimated Subject Value Price.sqft 99.48 \$2,387,520 PGIM 8.38 \$3,016,800 EGIM 8.68 \$2,937,312 Cap Rate 0.08 \$3,000,000

In this example, the expected subject value ranges from a low of \$2,387,520 to a high of \$3,016,800. The interpretation of this range of values is also a subjective part of the valuation process. Since the low estimated value is much lower, it may be appropriate to place less emphasis on that value and conclude that the subject value estimate is \$3,000,000.

### Conclusion

In this article, we talked about the sales comparison approach to real estate valuation. The sales comparison approach estimates market value for a property using recent sales data from other similar properties. The sales comparison approach process typically involves making adjustments because no two properties are exactly alike. We discussed several causes of adjustments and the walked through a simple example showing how the sales comparison approach works.

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