Every commercial valuation, from a broker’s one-page opinion to a licensed appraisal, leans on some mix of three methods. They have plain names: the income approach, the sales comparison approach and the cost approach.
Each asks a different question about the same building. When the three answers agree, the value stands steady. When they do not, the gap tells you something about the building or the market.
One building, three questions
- Income: what is the building’s income worth to a buyer?
- Sales comparison: what have buyers recently paid for buildings like it?
- Cost: what would it cost to buy the land and build it again, less the wear it already shows?
An investor buying a strip center thinks in income. A business owner shopping for a shop building thinks in sales and cost. A sound valuation leans on the approaches the likely buyer would use, and says why.
First, the best use
Before any approach runs, a valuation asks what the property is for. The term is highest and best use: the use that is legally allowed, physically possible, financially workable and worth the most. For most buildings the answer is the current use, and the question takes a paragraph.
Sometimes it takes longer. Say a 2,400 square foot former house, now used as an office, sits on a lot zoned for commercial use, and the numbers are illustrative. As an office it might be worth $310,000. As a cleared site, the land might be worth $360,000, less $25,000 to demolish the house:
$360,000 less $25,000 = $335,000
If the site is worth more empty than the building is worth standing, the building is no longer the point. The three approaches then price the land and its likely use, and an owner deciding whether to renovate needs to know that first.
The income approach
The income approach turns income into value. The common form is direct capitalization: one year of stabilized net operating income (NOI) divided by a cap rate drawn from comparable sales.
Value = NOI ÷ cap rate
Stabilized means a normal year: market vacancy, a market management fee, no one-time income. The article on cap rates, explained for owners walks through those inputs line by line.
For buildings with uneven income, such as a lease-up or a major tenant leaving in two years, a discounted cash flow does the same job year by year. It projects income over a holding period, adds a sale at the end and discounts each year back to today.
The income approach leads for any building bought for its rent: strip centers, multi-tenant office, single-tenant net lease and small multifamily.
The sales comparison approach
The sales comparison approach starts from what buyers paid. Find recent sales of similar buildings nearby, convert each to a common unit (usually price per square foot) and adjust each one for how it differs from the building being valued.
The usual adjustments:
- Date of sale: if the market has moved since the sale closed
- Location: traffic, visibility, access and neighborhood
- Size: smaller buildings can sell for more per square foot
- Age and condition: roof, mechanical systems, finish
- Tenancy: a full building and an empty one are different products
The approach is only as good as its sales. In a Wyoming town with three relevant sales in two years, each adjustment carries more weight and has to be argued in writing.
The cost approach
The cost approach asks what it would cost to replace the building today:
Value = land value + replacement cost new, less depreciation
Depreciation here is not the tax kind. It is the loss in value from three sources: physical wear, functional problems such as low ceilings or an awkward layout, and outside factors such as a weaker market or a rerouted highway.
The cost approach fits newer buildings, special-purpose buildings that rarely sell, and owner-occupied buildings where a buyer weighs buying against building. For a 40-year-old strip center it is weak, because estimating four decades of depreciation is mostly judgment.
A worked example
The numbers below are illustrative. Say an owner has a 10,000 square foot light industrial building in Gillette, built 12 years ago, with one tenant on a net lease at market rent.
Income approach. Market rent of $10.00 per square foot, net, is $100,000 a year. Less a 6% vacancy allowance ($6,000) and $6,000 of costs the tenant does not reimburse, NOI is $88,000. Local sales support an 8.25% cap rate:
$88,000 ÷ 0.0825 = $1,066,667
Sales comparison approach. Three recent sales of similar buildings, adjusted to the subject:
| Sale | Price per sq ft | Adjustments | Adjusted |
|---|---|---|---|
| A | $96 | Older building, plus 8% | $104 |
| B | $118 | Better location, less 6%; newer, less 5% | $105 |
| C | $101 | Smaller lot, plus 5% | $106 |
The adjusted sales sit at $104 to $106 per square foot. At $105:
10,000 square feet × $105 = $1,050,000
Cost approach. The land is worth $180,000. Building the same structure new would cost about $135 per square foot, or $1,350,000. Say twelve years of wear on a building with a long life works out to 20% depreciation, or $270,000:
$180,000 + $1,350,000, less $270,000 = $1,260,000
How the three are weighed
The last step is called reconciliation. It is not an average. It weighs each approach by the quality of its evidence and by how well it matches the way buyers think about this kind of building.
In the example, income and sales agree within about $17,000. The cost approach runs about $200,000 higher.
That gap says something. At today’s rents, building new would not pay, so a buyer will not pay replacement cost for an existing building. The cost approach has not fully counted that outside depreciation, so it gets the least weight.
A reasonable reconciliation leans on the income approach, checks it against the sales and treats cost as a ceiling. The conclusion: about $1,060,000, in a range of $1,030,000 to $1,090,000.
Notice what the reconciliation does not do. It does not add the three numbers and divide by three. That would give about $1,126,000, a figure no buyer in this market is likely to pay.
When the approaches disagree
A gap between approaches is a finding, not a failure. The direction of the gap usually points to the reason:
- Sales well above income. Buyers may be owner-users paying for a place to run a business, or the building’s rents may be below market. Either way, the income figure deserves a second look.
- Income well above sales. The leases may be above market, or a strong tenant may be propping up a weaker building. Ask what happens when those leases end.
- Cost well above both. Rents in the area do not support new construction, as in the example. Expect little new competition, and little reason for a buyer to pay replacement cost.
- Cost well below both. Land may be scarce, or the market may be rising faster than building costs. New supply may follow.
Each of these is worth a sentence in the report, because each one says something about the risk of owning the building.
Which approach leads, by property type
| Property type | Leads | Supports |
|---|---|---|
| Strip center, multi-tenant retail | Income | Sales |
| Single-tenant net lease | Income | Sales of similar leased buildings |
| Small office | Income | Sales |
| Industrial and flex | Income or sales | Cost, for newer buildings |
| Owner-occupied building | Sales | Cost |
| Small multifamily, five units and up | Income | Sales |
| New or special-purpose building | Cost | Income, if leased |
The table is a starting point, not a rule. A vacant strip center may lean on sales because there is no income to capitalize. A ten-year-old owner-occupied shop with a credible market rent may lean on income.
Questions to ask any valuation
- Which approaches were used, and why were the others left out?
- Is the income stabilized, or does it include one-time items?
- How many sales were used, how old are they and how far away?
- Is each adjustment explained, or just a percentage in a grid?
- Where did the construction cost estimate come from?
- How were the approaches weighed, in words?
A report that answers these in writing is one you can defend to a buyer, a lender or a county assessor. A report that cannot answer them is a number, not a valuation.
Licensed appraisers use the same three approaches. So do our consulting reports, which are opinions of value, not appraisals. For the vocabulary, our glossary of lease and valuation terms defines NOI, cap rate, highest and best use and the rest in a sentence each.
Put the three to work
A valuation advisory report uses the approaches that fit your building, shows each one and explains the weighting in words, with a site visit and a sensitivity table, in 10 to 15 business days from $3,500 per property (indicative). Our property valuation service lists the shorter formats, including a five-day snapshot. A free 30-minute scoping call tells you which one fits your question, followed by a fixed-fee quote in writing.
