Q: What is an Opinion of Value?
-Connie M., Retail Plaza Owner
A: Parts 1 through 3 of this four-part response outlined three methods of valuing commercial real estate in order to create an Opinion of Value: the Direct Comparison method, the Cost Approach, and Direct Capitalization as it is employed for the Income Approach. In our final installment, the use of Yield Capitalization, also known as pro forma modeling and as discounted cash flows, is examined.
The main difference distinguishing Yield Capitalization from Direct Capitalization in commercial real estate is that a lengthier period of time is analyzed, creating a more dynamic representation of cash flows. Rather than a single year’s cash flow being considered, several years will be calculated and distilled into one pro forma statement that accounts for mortgage payments and related expenses in its reconstructured income and expense statements.
Yield Capitalization reflects the value of a projected income stream assessed from discounted cash flows. This method converts future income from a property into present value by discounting the income from each year with a suitable discount rate.
Irregular income streams are not uncommon, and variables such as rent escalations are anticipated and factored into pro forma statements. Yield Capitalization is increasingly popular and relied upon among Realtors and investors alike. A complete statement employing Yield Capitalization might look like this typical sample:
Opinions of Value Concluded
Each method of informing an Opinion of Value has strengths and weaknesses. Employing two or more of these methods is advisable. The Cost Approach is usually not a major consideration in valuing income producing properties. Direct Comparison and Direct Capitalization for properties of a value up to five million dollars is generally sufficient. Multi-tenanted properties with values in the five-to-10-million dollar range are best served with the combination of Direct Comparison and the pro forma modeling of the Income Approach. Implementing Yield capitalization often results in higher prices for the seller, while appealing to sophisticated buyers. This chart offers a final illustration of the advantages and disadvantages of each of the methods discussed in this series: