Commercial real estate valuation is a fundamentally different process from residential appraisal, and one’s success in today’s economy depends upon one’s ability to exercise sound and appropriate appraisal methods.
This guide to the best commercial real estate valuation methods will empower you to choose your investments according to the most relevant data available.
Residential vs. Commercial Real Estate Valuation
Real estate valuation estimates the future financial benefits of owning a particular property. Many different valuation methods are adaptive to residential and commercial appraisals, but commercial real estate valuation is generally more complex and adaptive to additional data.
While many commercial investors use traditional methods, some rely on state-of-the-art data governance and management tools to improve the accuracy of their appraisals.
The Basics of Commercial Real Estate Valuation
Four primary factors influence the value of a property:
- Demand: the quantifiable collective need or desire for property ownership.
- Utility: the property’s ability to satisfy an owner’s financial and non-financial needs.
- Scarcity: the availability of competitive properties.
- Transferability: the feasibility of a property sale or transfer.
These four factors set the foundations for valuation methods. Still, one must also consider the price of acquisition, the cost of maintaining the property, and the legal, social, economic, and environmental factors contributing to value.
Who Appraises a Commercial Property?
Although some investors conduct their appraisals, others may hire in-house or third-party appraisers to estimate a property’s value. Appraisers follow a selection procedure to determine a property’s value, and their conclusions represent the fairest appraisal of the investment.
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Commercial Real Estate Valuation Methods
Assessing the value of a commercial property requires effort. Appraisers typically rely on a combination of the following methods to determine a property’s value, and a complete appraisal typically depends upon several estimates. Mastering all four valuation methods will undoubtedly contribute to your success in commercial real estate investing.
Sales Comparison Approach (SCA)
The most common real estate appraisal method is the sales comparison approach.
This approach compares one property to comparable properties in the local area. Comparable properties may consist of those currently on the market or recently sold since this approach works best when appraisers consider current market conditions.
This approach presupposes that the value of a property consists of the sum of the values of its features, such as geographic location, condition, age, dimensions, amenities, and more.
Although somewhat reductive, this approach is relatively reliable. Real estate professionals often use the SCA to conduct comparative market analysis, assessing multiple properties.
How to Conduct a Commercial Property Appraisal Using Sales Comparison Approach
To use SCA, simply assemble a list of the home’s features and amenities and search the Multiple Listing Service (MLS) for comparable homes.
Consider features such as
- Square Footage: Both homes should have similar dimensions when using this method. If they do not, calculate the price per square footage for the comparable home and apply it to the overall dimensions of the home you want to appraise.
- Geographic Location: Geography is one of the most impactful factors in the price of a home, so look for similar neighborhoods, local amenities, views, proximity to schools and workplaces, environmental conditions, and more.
- Features: Consider the number of bedrooms and bathrooms, utilities, and special features (pools, terraces, porches, furnishings, architectural details, etc.)
- Condition: Both homes should be in comparable condition.
Once you have found a comparable home, use the asking or selling price to assess the value of the home you are attempting to appraise.
Pros & Cons of SCA
As with many other valuation methods, SCA is most accurate when paired with another approach.
No two homes are the same, so the estimate you generate with this method may not be accurate.
Remember to consider special and unique features such as the economy, the market, and local socio-political conditions.
Ultimately, SCA is best for informal appraisals and quick comparisons and should complement another method.
Cost Approach
The cost approach is a commercial real estate valuation method that relies upon the estimated price a buyer should pay for a given property compared to the cost of building a similar structure.
This method works best for new properties since it sets the estimated price equal to the cost of new development. This valuation method is less reliable than others since many investors acquire pre-owned properties.
How to Conduct a Commercial Property Appraisal Using Cost Approach
The cost approach focuses on the cost of replacing or reproducing a given building:
- Reproduction: estimates the cost of reproducing an identical building to the one under consideration.
- Replacement: considers a parallel development using newer materials and modern construction methods.
Investors can estimate the value of a commercial property using the following cost-dependent calculation:
Cost-depreciation + land worth = property value.
To calculate depreciation, you can divide the cost by the property’s useful lifetime or use a different depreciation equation. To find land worth, find comparable land or subtract the cost of construction and development from a property’s price.
Pros & Cons of Cost Approach
The cost approach is less reliable than others and most appropriate for new properties or unique investments. If comparable land is not available, you must estimate land value, which can yield accurate numbers. Additionally, this approach rests on certain imperfect economic assumptions, which can affect the valuation.
To that end, this valuation method works best for investors seeking to acquire new or unique properties. Investors should use additional valuation methods if attempting to yield an accurate number.
Income Approach
The income approach is a valuation method that relies on projected rental income for a given property. This method is also known as the income capitalization approach because it relies on dividing a property’s net operating income (NOI) by the capitalization rate. The capitalization rate is the estimated rate of return for an investment property.
The income approach works best for income-producing properties, and an accurate estimate will depend on the property’s current condition since repairs and renovations can significantly lower future profits. Alternatively, some investors compare a given property with a competitive investment featuring similar metrics.
How to Estimate Value Using the Income Capitalization Comparison
To use this commercial real estate valuation method, simply use the following equation:
Net Operating Income (NOI) / Capitalization Rate = Property Value
For example, a commercial property with an NOI of $600,000 and a cap rate of 7.5% is worth $8 million.
To set up the equation, find a comparable property’s NOI and given capitalization rate. Alternatively, you can leverage the expertise of a professional or use full-service investor management software to compute the numbers. Consider your repair costs and vacancy rate since these figures impact your net operating income.
Pros & Cons of Income Capitalization Approach
The income capitalization approach is ideal for income-generating properties, and it works best for those with existing historical data. This method hinges on accurate, quantifiable data, so investors must carefully base each estimate on existing metrics, such as inflation rate, depreciation, and vacancy rates.
Income growth should rely on market trends and supportive data since an accurate property value depends on actual data. At the same time, a reliable cap rate should reflect stabilized income, neglecting to account for one-off expenses like lease termination fees.
Gross Rent Multiplication
A gross rent multiplication method generates property value for income-generating properties using property price and gross rental income. This approach is similar to the income capitalization comparison approach because it is a comparative metric that uses similar properties to generate a value figure.
The capitalization rate typically considers vacancies and expenses, whereas gross rent multiplication does not. Additionally, the cap rate uses net income, while GRM considers gross income.
For this reason, the cap rate is a more accurate, though time-consuming, metric, while GRM is more appropriate for quick and effective estimations of profitability across multiple properties.
How to Estimate Property Value Using the Gross Rent Multiplication Method
There are two types of gross rent multiplication calculations. To find a GRM, simply divide property price by gross rental income. The equation is as follows:
Property Price/ Gross Rental Income = Gross Rent Multiplier (GRM)
For example, if an investor wants to purchase a $6 million property with a monthly rental income of $51,000 (multiplying the monthly payment by 12), the gross rent multiplier will amount to 9.8.
Because GRM is a comparative figure, this number alone means little. An optimal GRM is usually between 4 and 7, so a GRM of 9.8 may be too high. A lower GRM is generally better because it signals a more lucrative investment. Most GRMs will fall into single digits due to the nature of the equation, and GRMs tend to decrease as property prices rise.
To find property value based on a GRM, complete the following calculation:
Annual Gross Rent x Gross Rent Multiplier = Property Value
With a GRM of 7 and an annual gross annual rent of $480,000, a property should be worth $3.35 million.
Although the property’s price is typically readily available, gross rental income estimates may require more research. You can examine a previous owner’s rent roll or seek out rent rolls for similar properties, but if your investment is unique, you may have a more challenging time estimating your gross annual rent.
Pros & Cons of Gross Rent Multiplication
While some investors consider only GRM when assessing different properties, using the GRM to find property value will yield a more reliable figure for valuation. Gross rent multiplication is helpful with the following:
- Comparing several properties in a time-efficient manner
- Identifying the benefits of acquisition when the sale price may not reflect actual property value
- Quickly determining the potential return on investment for a given property.
GRM allows investors to make sound decisions using reliable data and is thus considered one of the best metrics for property valuation. However, GRM works best across multiple properties since it is a comparative metric. Investors should examine competitive investment GRMs to interpret the obtained figure’s implications.
Because GRM alone does not provide sufficient information to determine the ROI of an investment, investors typically undertake the second equation to find property value.
Additionally, GRM does not consider operating expenses or vacancy costs, so it works best for individual properties when coupled with another valuation method. Ultimately, most valuation methods offer limited insight when applied singularly.
Before You Begin
Making sound commercial real estate investments is an art that requires practice. If you persist despite setbacks, you will learn to quickly and efficiently assess property value and generate lucrative returns. Ultimately, your assessments will only be as good as your data, so you should ensure that you work with a qualified professional or use a commercial real estate platform to guide your investments. Contact EXtrance today to learn more.