Five Approaches to Evaluating Value of a Commercial Real Estate Property

Regardless of the asset type, both sellers and purchasers must eventually confront the question, "How much does it cost?" A response to this necessitates the computation of the asset's proper value using an acceptable valuation method.

Commercial real estate properties are no exception. If anything at all, they only add a layer of trickiness to the valuation aspect.

Commercial real estate consists of a pool of different property types: office space, retail space, industrial buildings, multifamily housing, to name a few, and being aware of the know-how of each is essential in decluttering the valuation process.

What are the Five Most Used Valuation Approaches?

  • Cost Approach

The idea behind the cost approach is that a buyer will not be inclined towards paying more for a property than the amount that would cost to purchase land and build a comparable structure. It obtains the value by assessing what building a property from scratch would cost.

Steps involved:

  • 1) Estimate the market value of the land
  • 2) Estimate the building's replacement cost
  • 3) Deduct depreciation, including physical deterioration, functional, location and, economic obsolescence.

This method helps answer whether the subject property is worth buying or building a new one would make more sense. It's often used for newly constructed properties with unique features or properties for which comparable deals are few.

This approach is usually considered the upper limit of value. However, at the same time, it is vulnerable to the changes in local laws as it determines the cost of property considering its best and most productive use. It also fails to consider the income the said property can generate.

  • Sales Comparison Approach

The sales comparison approach, also known as the market approach, is often used to value multifamily real estate and works on a comparison basis. It states that a buyer would not be willing to pay for a property more than what a similar property costs in the same market.

The purchasers' rational behavior is assumed in this method, and the price paid by them is used to represent the market. In a market where numerous similar properties have recently sold or been advertised for sale, a sales comparison is helpful.

Some of the factors that this method takes into account are square footage, location, type of construction, year of construction, infrastructure, size, and demographic. This helps the market participants get real-time and relevant market data and hence, make a more informed decision. However, because finding an exact match for the subject attribute might be difficult, adjustments for differences are frequently made.

The fact that markets can often be inefficient makes this method prone to inaccuracies. Several aspects like vacancies, collection losses, abnormal and unexpected expenses fail to become a part of the equation.

  • Income Capitalization Approach

This is one of the most commonly used valuation methods to appraise commercial real estate. The critical determining factor of value is the amount of revenue (typically in the form of rent) that the property can be projected to earn, as well as the future resale worth of the subject property. The types of commercial real estate that can be valued using this method include retail centers, multifamily housing, office buildings, and other income-producing properties.

This method consists of 2 ways:

  • 1) The direct capitalization way
  • 2) The discounted cash flow way

Both of these methods use Net Operating Income (NOI) to value an asset. Net Operating Income is the amount of income remaining after subtracting vacancy and collection loss and operating expenses (insurance, property taxes, utilities, maintenance, repairs, etc.) from potential gross income.

Capitalization rate (cap rate) is usually obtained using market sales data of similar properties. After accounting for the properties' distinctive qualities, the value is calculated by dividing the property's net annual income by the cap rate.

For example, the value of a property with an annual net operating income of $100,000 and a cap rate of 4% will come out to be $2,500,000 ($100,000/0.04).

With the discounted cash flow way, value is calculated using the present value of the property's future cash flows and an appropriate discount rate.

  • Value per Gross Rent Multiplier

This is used as an alternative method to the income approach. The difference between these two methods is that the income method uses net operating income while the gross rent multiplier uses gross income as an input.

Steps involved:

  • 1) Divide the sales price by the gross rental income of all comparable properties to arrive at the GRM ratio, which is then averaged.
  • 2) Use the derived GMR with data of the property at hand to obtain its value.

To illustrate, suppose a rental property in the neighborhood sold for $500,000 and had an annual gross income of $100,000. The GRM would be calculated by dividing the sale price by the annual gross income, i.e., $5,00,000/$100,000 = 5.

Now, if the subject rental property generates an annual gross income of $50,000, then based on this method, the value of the property would be $250,000 ($50,000 * 5).

In some ways, this strategy aids in the selection of inexpensively available properties based on their income-generating potential.

  • Value Per Door

As the name suggests, this method divides the total value of a property by the number of doors. This works as a reference point for other similar properties. The value per door method works better for multi-unit properties than single-unit structures.

For example, a building with ten apartments valued at $700,000 would have a per door value of $70,000 ($700,000/10). This value per door can be used to value other similar multi-unit properties in the area.

This method, as convenient as it may appear, is not without flaws. This method ignores essential elements such as apartment size, quality, cost differences, and other property-related characteristics.

These five approaches to computing the value of an asset should help you determine if a commercial real estate property will be profitable.

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