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Taking the Real Estate Exam: Valuing a Business Property

Coffee shop Suppose you're asked a question on the real estate exam about valuing a commercial property. You know that the general rule is that you use the income approach to value a commercial property. But what if the commercial property is not rented out? What if it's used by the property owner for his own business (such as a restaurant or a small shop)? Does that change the method you use to appraise the property?

We think the income approach is still the correct method for appraising this commercial property, even though the income generated by the property owner's business isn't necessarily the same as the rental income that the property would produce. An appraiser valuing a commercial property doesn't have to know the income generated by the building, although it would certainly makes things easier. What he can do instead is to look at comparable commercial properties, similar in location, size, and function, to find an appropriate market rent. (An appraiser would also do this when appraising a vacant building, or one whose lease is about to expire.)

That doesn't mean the appraiser is using the sales comparison approach, though, even though he is using comparables. He would use comparables only to get things started, and then go on to estimate the property's value using the income approach (applying a capitalization rate to the property's income).

For instance, suppose the owner of a small commercial property runs a café in the property. The café is barely breaking even, and many months the owner loses money. To find the value of the property, contrary to what you might expect, an appraiser would not look at the café's monthly receipts. A café may not be the best use of the property, or maybe there's something uniquely wrong with that particular café that doesn't indicate how other cafés might fare in that same space. Instead, the appraiser would simply look for comparable commercial properties to see what their current contract rents are. They might be other properties of a similar size and location that are rented out to other cafés, or simply similar nearby properties that could house a café. Those comparable rents would be the basis for the property's economic rent (and the basis for the property's potential gross income).

Do you think we have this one right? Feel free to discuss it in the comments. And as you've probably noticed, this is a question that falls into one of the real estate exam's many grey areas... which is why we're always to happy to provide support, either by email or by phone, to students who are preparing to take the real estate exam.