Owner-Occupied Medical Office: Cost, Income, and a Below-Market Lease Sale
An assessor is valuing a 24,000-square-foot medical office building built in 2008 and owner-occupied by a six-physician group. There are no recent fee-simple sales of owner-occupied medical buildings, but one comparable 20,000-square-foot building sold for $4.2 million last year while subject to a five-year lease at $19 per square foot when market rent was $24 per square foot. The subject’s replacement cost new is $4.8 million; land is $600,000; physical deterioration is 12%; functional obsolescence is $250,000; and external obsolescence is estimated at 5% of the depreciated improvements. Market rent for the subject is $24 per square foot; vacancy and collection loss is 8%; operating expenses are 30% of effective gross income; and the market capitalization rate is 8.25%. The owner reports no rental income because the group occupies the building.
1. Calculate the income approach indication and explain why market rent, not the owner’s actual occupancy, is used.
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Use market rent because the appraisal is a fee-simple valuation of the real estate, not a business valuation of the medical practice. The owner pays no rent, but a hypothetical buyer would expect market rent for the space. Actual owner occupancy is relevant to physical use, not to the income capitalization.
- Potential gross income: 24,000 sq ft × $24 = $576,000
- Vacancy and collection loss: 8% × $576,000 = $46,080
- Effective gross income: $529,920
- Operating expenses: 30% × $529,920 = $158,976
- Net operating income: $370,944
- Capitalized value: $370,944 ÷ 0.0825 = $4,496,291 (rounded)
The income approach indicates about $4.50 million. The assessor should verify that market rent, vacancy, expenses, and the cap rate come from comparable medical office data, not from the owner’s practice revenue.
2. Calculate the cost approach indication, including external obsolescence, and identify the major judgment in the depreciation estimate.
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Start with replacement cost new and deduct physical and functional depreciation before applying external obsolescence to the depreciated improvements:
- Replacement cost new: $4,800,000
- Physical deterioration: 12% × $4,800,000 = $576,000
- Functional obsolescence: $250,000
- Depreciated improvements before external obsolescence: $4,800,000 − $576,000 − $250,000 = $3,974,000
- External obsolescence: 5% × $3,974,000 = $198,700
- Depreciated improvements: $3,775,300
- Add land: $3,775,300 + $600,000 = $4,375,300
The cost approach indicates about $4.38 million. The major judgment is whether the 12% physical deterioration and $250,000 functional obsolescence are supported by the building’s condition and layout. External obsolescence should reflect market-wide or locational factors, not the owner’s occupancy.
3. Reconcile the cost and income indications and explain how the $4.2 million comparable sale should be adjusted for its below-market lease.
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The income approach indicates about $4.50 million and the cost approach about $4.38 million. They bracket a reasonable range. For an owner-occupied special-purpose property, the income approach is often the strongest indicator when market rent and expenses are well supported; the cost approach is a useful check on whether a buyer could reproduce the building. A final value near $4.45 million is defensible if the market data are reliable.
The $4.2 million sale is not directly comparable as a fee-simple transaction because the buyer acquired a property burdened by a five-year lease at $19 per square foot when market rent was $24. The leasehold disadvantage is $5 per square foot × 20,000 square feet = $100,000 per year for five years. The sale price should be adjusted upward to reflect market rent, or the sale should be used only to support the lease terms and capitalization rate. The assessor should not simply average the unadjusted $4.2 million with the income indication.