This section is from the book "Practical Real Estate Methods For Broker, Operator & Owner", by Thirty Experts. Also available from Amazon: Practical Real Estate Methods for Broker, Operator, Owner.
The selling price of property ordinarily reflects the rental of the property, which is the source of its value, but this is modified by the prospect of the future rental of the property. And there is an apparent exception to the rule that values follow and are based on rentals in the case of high-class residences in a high-class district, which seldom rent for a reasonable return on their value. This is no doubt due to the fact that ownership of such a property, which gives the owner its permanent occupancy and is paid for in the form of interest on the cost, makes this worth more per annum than the temporary occupancy of the house, which is paid for by the tenant in the form of rental. Disregarding vacant city land, which may be said to have only a future or speculative value and is not accepted as mortgage security by any mortgage company in Europe, nor by conservative companies in this country, the ordinary method of appraisal of improved property is to add to the estimated land value the present cost of the buildings, with an allowance for age and depreciation. The aggregate of these values should always be checked wherever possible by capitalizing the net rentals of the property, after deducting expenses of all kinds, to find if the building's commercial value is equal to its structural value. Wherever a building is misplaced or badly designed, loss of income over a period of years is a sure result; and examples could be given of many expensive buildings, the cost of which has been entirely thrown away, as is shown by the fact that the net rentals produced by them have been less than those produced by adjacent properties improved with buildings of trifling cost. The structural value of the improvements, considered by itself, is therefore an entirely unsafe guide in such cases.
On the other hand, to rely on the net rentals alone would be unsafe, since different classes of property are capitalized on a different interest basis. For example, a retail store property rented on long lease to an entirely responsible tenant might be capitalized on a basis of 5% net return, where a tenement house with a large number of tenants and corresponding vacancies and difficulties of collection would naturally be capitalized at a considerably higher rate.