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Trying to estimate the value of a piece of real estate seems to be everyone's favorite pastime. I've discussed this subject in detail in my book, 'What Every Real Estate Investor Needs to Know About Cash Flow"; in previous articles, on PBS's Wealthtrack; in line at the supermarket, and just about everywhere else I'm allowed to talk out loud. Although I thought I had covered the waterfront pretty well on this topic, I continue to be surprised by the number of people who still don't fully understand that there are several approaches to estimating value, and that it is important to choose the one best suited to the particular property you have in mind.

First, some necessary preliminaries. Any (actually, every) real estate appraiser will tell you that there are three approaches to value: the cost approach, the market data approach, and the income approach. While they will often try to reconcile these approaches when appraising a particular property, in many cases it is clear that one of the three methods stands out as the most appropriate for that property.

The Cost Approach

The cost approach uses the cost of reconstructing the property at today's prices (land included) and then whittles that number down because of factors such as physical depreciation and functional obsolescence. In my experience it tends to be most useful if the property is squeaky new (i.e., you haven't yet scraped the labels off the plate glass windows) but tends to become more subjective as the property becomes less than brand new. The adjustments also tend to be pretty subjective, which may be all right if the person making those adjustments does so for a living all day long (for example, a professional appraiser), but are not likely to be so reliable otherwise. Also, you'll need a solid estimate of the land value, often a difficult task in its own right.

For the typical investor or developer, cost may be useful to confirm valuations made with other approaches but otherwise may be difficult to apply in a way that's reliable enough to be the basis of an investment decision. So, for the purpose of our discussion, let's skip this approach and focus instead on the distinction that I find tends to muddle the understanding of value for many novice ' and some not so novice ' investors. When do you use the market data approach to value and when do you use the income approach? The question may sound academic. It's not. It's the difference between recognizing the realistic value of a property or perhaps missing it by a country mile.

The Market Data Approach

The market data approach is based on comparable sales. In other words, you can reasonably expect that a property will sell for something close to the price of similar properties located close to the subject, i.e., comparables located in the same market. You would of course make adjustments for distinguishing features ' the presence or absence of certain amenities found in the comparable properties ' but it is the market as much if not more than the property itself that drives the value.

When do you use this method to value a property? The poster child for the market approach is the single-family home. When you shop for such a home, you look at the amenities that the house has to offer and you look at how much other houses in the neighborhood have sold for. You might say, 'Other four-bedroom colonials in this neighborhood have sold recently between $680,000 and $720,000 and I should base my offer on that information.' It's unlikely, however, that you would say, 'I can probably get $2,000 per month rent for this, so I'll base my offer on whatever price gives me a positive cash flow.'

You would also take note of the local economy when considering how the value of this property might grow over time. Strong employment for example might increase demand and therefore increase prices. If prices in a neighborhood have recently increased on average by about 5%, chances are good that most individual properties have indeed increased by a similar amount. Likewise, chances are good that future increases or decreases will affect most properties in that neighborhood more or less equally. A rising tide lifts all boats. Again, it's the dynamics of the market at work here.

The Income Approach

Now consider an altogether different kind of property: an office building or shopping center or fairly large apartment building. You are not going to look for comparable sales of regional shopping malls to decide how much to offer. Income properties are bought and sold strictly for their ability to produce a net income. So long as the property's main appeal is not for the use or occupancy of the owner, it is in the purest sense an income property. A person who buys a garden apartment complex, an office tower, or a shopping center is probably not looking for a place for his family, his office, or his store to occupy. He is looking for an income stream, a cash flow.

This investor will capitalize the property's anticipated Net Operating Income to arrive at an estimate of value.

Some Examples

It should be clear enough that you would use the market data approach when buying a home and the income approach when buying a shopping center or office building. It's the gray areas that are tricky and can trip you up. Let me describe some typical situations that we hear most often:

You buy a single-family house for investment as a rental property. Unless the neighborhood is made up entirely of pure rental properties, you do not want to base your estimate of the property's value on its rental income. If the other houses in the neighborhood are being bought and sold as personal residences, then prices will be driven by comparable sales, not by potential rental income. In other words, when you buy this property you will pay a price based on the market for homes in the area; and when you sell it you can expect a price driven by that same market.

Even though the price at which you buy and the price at which you sell will not be a function of the property's rental income, it is still critically important to perform cash flow and resale. The house may not be an income property in the purest sense, but that is how you're using it. You're buying an income stream and you need to estimate what you can expect as yearly cash flows and how much you'll derive from the final cash flow: the proceeds of sale. That's what investment analysis is all about.

You buy a multi-family house for investment as a rental property. This one is trickier yet. You need to ask yourself, 'Who is the most likely buyer of this property? ' an owner/occupant or an absentee-owner/investor?' One neighborhood might be characterized by a preponderance of 3- to 6-unit multi-family, larger apartment buildings and small commercial properties. The most likely buyer here would probably be an investor; hence the income approach would be best for estimating value.

Another neighborhood might contain a good number of single-family homes along with duplexes (many of them owner-occupied) and some triplexes. The buyer of a multi-family here is probably going to be an owner/occupant, someone who is buying a home that has rental income as one of its amenities. The value of this property will probably be driven by comparable sales, not by the potential rent income.

You buy a small commercial property. Commercial is commercial, right? That means investment, which means the rent income determines its value. Usually, but not always. This situation is analogous to the owner-occupied multi-family. Consider a small professional office or a small, freestanding retail building. The prime prospect for the office might be a doctor or lawyer, using the space for his or her practice. The retail building might be attractive to a local storeowner. Once again, if the appeal is to an owner/occupant rather than an absentee investor, it is less likely that the value will be determined by the rent potential and more likely that it will be a function of the local market for similar properties.

Conclusion

As I said at the outset, understanding when one approach to value might be more appropriate than another is not just an academic exercise. So often we hear people talk about how they expect the value of their income property investments to rise because 'real estate (i.e., their home) is going up.' As Gershwin could tell you, it ain't necessarily so. An example I've used before (but I'm allowed to repeat myself) is that of a rapidly growing community where local developers feel inspired to build office space ' so much space that office rents and office building values decline even while home prices rise.

Similarly, we find folks who are surprised that a duplex or triplex will sell at a price much too high for an investor to achieve a positive cash flow, not realizing that the property is selling as a home that incidentally has rental income and not as a strictly commercial income property.

Estimating the value of a piece of real estate will probably always remain part art and part science. Matching the right methodology to a particular property is an essential first step for anyone trying to make real-world investment decisions he can live with.