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Five Approaches to Evaluating Value of a Commercial Real Estate Property

Published: 08-18-21 Category: Investing

Specializes in providing actionable insights into the commercial real estate space for investors, brokers, lessors, and lessees. He covers quarterly market data reports, investment strategies, how-to guides, and top-down perspectives on market movements.

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This article was updated on 7/24/2023.

Regardless of the asset type, both sellers and buyers 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 property evaluation is 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, and multifamily housing to name a few, and being aware of the know-how of each is essential in decluttering the valuation process.

Let's look into how to evaluate commercial real estate and the intricacies of commercial property evaluation.

What Are the Five Most-Used Commercial Property Evaluation Approaches?

The five most-used commercial property evaluation approaches are the cost approach, the sales comparison approach, the income capitalization approach, the value per gross rent multiplier approach, and the value per door approach.

#1 – 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. Essentially, this approach obtains value by assessing what building a property from scratch would cost.

The steps involved include:

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

This method helps answer whether the subject property is worth buying or whether 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 commercial property evaluation approach is usually considered the upper limit of value. However, at the same time, it is vulnerable to 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 that said property can generate.

#2 – 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 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, and abnormal and unexpected expenses fail to become a part of the equation.

#3 – Income Capitalization Approach

This is one of the most commonly used commercial property evaluation 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; and
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.

The 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.

#4 – 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.

The steps involved include:

1) Dividing the sales price by the gross rental income of all comparable properties to arrive at the GRM ratio, which is then averaged; then
2) Using 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 commercial property evaluation method aids in the selection of inexpensively available properties based on their income-generating potential.

#5 – Value Per Door

As the name suggests, this commercial property evaluation 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: It ignores essential elements, such as apartment size, quality, cost differences, and other property-related characteristics.

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

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