Advantages and Disadvantages to Real Estate Index Approaches

So many valuation approaches, so many valuations.

There's generally not a "best" approach, but there is often a best approach for a certain property. It depends. Start with the income approach—it's great in terms of flexibility, as you can include all information in the cash flows used, and discount rates can be chosen for each one. However, gathering all of that information can be a real challenge. What else would you think is a potential weakness here?

No. It can all be easily put into a spreadsheet, really. But small estimation changes _can_ lead to large valuation changes.

Absolutely.

A one percentage point change in the discount rate can move a property from undervalued to overvalued, and it's very difficult to know which is more appropriate.

The cost approach is often thought to provide a sort of "upper limit" to a property's value. If something seems to be worth 150% of cost, then a developer will probably be building another one nearby. The main weakness is trying to estimate all of the depreciations of cost, such as functional and locational obsolescence. Given this, what sort of property might be best for the cost approach?

No. That can be a real challenge when using the cost approach. Consider the three types of obsolescence to estimate, as well as the physical deterioration to account for.

Right! A new building doesn't require as many depreciation estimates. There's little functional obsolescence since it's a newer design. There hasn't been enough time for a lot of locational obsolescence, and the physical depreciation is relatively small so far.

No. Big doesn't matter here. The cost approach can work well or poorly with a building of any size or price level.

Then for the sales comparison approach, the requirement is fairly straightforward: you need a market where similar properties are traded. If there aren't good comparisons, or if the market is thin, then it won't work so well. It can be a lot easier to gather the information needed for the sales comparison approach, but think for a moment about the information being gathered. What important assumption do you think is being made?

No. That's not necessary. As long as the properties maintain their traded values, this approach should work fine.

That's right! The buyers were hopefully all rational buyers paying market value. If there's euphoria in the market, then prices might be too high, and you could be just taking part in a bubble.

Not really. It's not important how the purchases were financed, just what the values are.

That's why it's important as a potential buyer to perform __due diligence__. If your valuations look good and you decide that you want a property, you'll often sign a letter of intent that basically says, "Yes, I want to buy this property if everything checks out." Then you check everything out. This includes lease history, operational expense bills (actually get the copies), an environmental inspection, an engineering inspection, a survey, compliance check, and verification that property taxes and assessments have been paid. What would you do if you discover some nasty surprise during this process?

Sure, that's fine. The letter of intent was conditional, and the condition was just violated. So you can just walk away. You could also renegotiate for a better price if you'd like. But you don't have to buy.

Sure, that's fine. The letter of intent was conditional, and the condition was just violated. So you can renegotiate for a better price. You could also just abandon the deal and walk away if you'd like. But you don't have to buy.

No, you don't have to do this. The letter of intent isn't an obligation, it's a conditional letter.

To summarize: [[summary]]

It's computationally intensive

Small estimation changes can lead to large valuation changes

A big building

A new building

An old building

Buyers paid cash

The sales prices are market prices

Properties will continue to be traded

Abandon the deal

Try to get a better price

Buy: the letter of intent is an obligation

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