Common techniques of real estate appraisal/valuation include comparable sales, income and cost approaches:
Comparable sales approach
Comparable sales approach values a property by comparing it with recent sales of similar properties after adjusting for differences in key characteristics such as condition, age, location, size and any price changes in the market.
Income approach values a property using direct capitalization or discounted cash flow methods.
Direct capitalization method
Direct capitalization method: Property value is determined by discounting the property annual net operating income (NOI) at the cap rate.
Net operating income
Net operating income (NOI) is a proxy for property-level operating cash flow similar to EBITDA and it equals gross rent minus operating expenses such as property taxes, insurance, utilities, repairs and maintenance, but before depreciation, financing costs and taxes.
The cap rate equals the discount rate minus the growth rate. Cap rate is determined from comparable sales, general market conditions, property quality, vacancy rate, etc.
Discounted cash flow method
Discounted cash flow method: Property is valued by discounting its future operating cash flows and a terminal resale/reversion value (similar to horizon value) at an appropriate discount rate. Reversion value is typically calculated using direct capitalization.
Cost approach evaluates a property’s replacement cost by estimating the market value of land and current rebuilding costs. Costs include materials, labor, improvements, architectural, engineering, environmental assessment, etc. It is adjusted to consider the location and condition of existing buildings.
REITs can be valued using either income-based or asset-based approaches and compared with market prices. The income-based approach is similar to direct capitalization in that it capitalizes some cash flow measures of the REIT using a cap rate.
Popular cash flow measures are funds from operations (FFO), which equals net income plus depreciation minus gains on property sales plus losses on property sales, and adjusted funds from operations (AFFO), which subtracts capital expenditures from FFO and is hence similar to free cash flow.
The asset-based approach works out the REIT net asset value (NAV), which equals market value estimates of assets minus value of liabilities. However, REIT shares typically trade at a price different from NAV due to premiums and discounts.