When purchasing, selling, or developing real estate, business owners should be attentive to the market value of their property. Put simply, market value is “the price a purchaser, who is willing, but not obliged to buy, would pay an owner, willing, but not obliged to sell, taking into consideration all uses to which the property is adapted and might in reason be applied.” Not only does market value drive transactions, but valuations are also integral for those seeking a mortgage. If the property is being used as collateral, market value will determine the amount of credit given to an individual. Further, market value factors into the amount of property tax charged on a portion of property.
Pennsylvania appraisers use three methods to arrive at a property’s market value: 1) the Sales Comparison Approach (SCA); 2) the Cost Approach Method (CAM); and 3) the Income Approach (IA). No one method is an exact science, and there are benefits and detriments to each based on the differing characteristics of your property.
- The Sales Comparison Approach
SCA compares the subject property to similar real estate transactions, considering each property’s features (such as bathrooms, garages, etc.). One major factor included in this comparison is geography. The compared properties should be located in the same neighborhood or town with similar proximities to schools, parks, and highways. The market’s constant fluctuation also requires the property be compared to recent sales. Finally, SCA requires comparison of real estate with a similar age and condition to the subject property.
SCA is the most common method to determine market value because appraisers can utilize this method on different types of real estate (new properties, old properties, undeveloped properties, etc.) However, we must keep in mind that no two properties are exactly the same, and this method is only effective upon a comparison of similar properties. Further, SCA may not be suitable for properties with unique locations, layouts, or features.
- Cost Approach Method
CAM determines market value by calculating the cost needed to effectively re-build any structures on the property, while also factoring in both the value of the land and any depreciation in value that occurs over time. CAM’s core formula is “Market Value = Land Value + (Cost of Building New – Physical Depreciation)”. SCA is often used within CAM to calculate land value.
While less common, CAM should be utilized for unique structures where no comparable properties are on the market. CAM is also best utilized for newer properties because there is less estimation concerning depreciation cost. Once a property ages, CAM is not a suitable valuation method.
- Income Approach
IA focuses upon an estimation of the income a property will produce. IA has three major factors, with the core formula being “Market Value= Capitalization Rate x (Effective Gross Income – Operating Expenses)”. Effective gross income is calculated by estimating the total amount a property could collect at 100% performance for the year. Operating expenses, meaning any necessary maintenance, repairs, utilities, insurance, etc., are subtracted from the effective gross income. Finally, the difference is multiplied by a capitalization rate. While there are intricate methods of calculating a capitalization rate, an examination of recent, similar property sales in the same location is a starting point to determine the rate.
IA can only be utilized effectively if there is enough accessible information to estimate income and operating expenses. IA is most commonly used in the valuation of commercial, income-producing property. However, IA may be the least effective method to reduce a property’s tax burden for large businesses that produce high income. IA should not be used to value residential properties.
A basic understanding of the above valuation methods, and when to use each method, will prove useful to any business owner involved in the purchase, sale, or development of real estate. If you have questions about this post or wish to seek more information, please contact the McNees, Wallace & Nurick’s State and Local Tax Group or Real Estate Group for assistance.