Whether you’re a seasoned real estate investor or a commercial appraiser, it’s important to understand how to value commercial property.
The value of commercial property plays a key role in determining how the asset will perform as part of a portfolio.
Commercial Real Estate Valuation
Calculating commercial property value is much different than calculating the value of residential real estate—even for the most adept appraisers.
With residential, most appraisers can look at comps in the neighborhood as a baseline, and then add or subtract to a property’s value based on specific criteria like square footage, number of bedrooms, and so forth.
CRE valuation is a whole different ball game, however.
The Importance of Commercial Property Valuation
Knowing the value of commercial property is important for several reasons, and for several parties.
At the most basic level, the value tells you the most probable price the asset would sell for present-day on the open market.
The value is also important when it comes to underwriting.
Most people don’t realize that getting an appraisal is not a required part of a purchase or sale. It’s typically only required when placing debt on a property.
In commercial real estate, most lenders want to see at least a 65% to 70% loan-to-value ratio before signing off on a mortgage.
An appraisal gives you that “value” baseline on which the lender determines how much debt it is willing to provide.
Owners and investors also care about commercial property value.
On the front end, knowing the value helps determine how much you might be willing to pay for a property. Once you’ve acquired the asset, it can help you make decisions about value-add opportunities.
For instance, a deteriorated 10-unit apartment building in Providence, RI might not warrant $75,000 in improvements per unit for an investor looking to flip the property.
The value of commercial property – both current and potential value – helps owners and investors make strategic decisions about how to position the asset relative to the rest of their portfolio.
How to Value Commercial Real Estate
There are multiple ways to value commercial property. Each has its own nuances, with some approaches requiring more specificity than others.
Here are a few of the most commonly used approaches that we’ll discuss in greater detail today:
- Sales Comparison Approach with Reonomy Comps
- Cost Approach
- Income Approach
- Gross Rent Multiplier (GRM) Approach
Reonomy Real Estate Comps: The Sales Comparison Approach
The “sales comparison approach,” often referred to as the “market approach,” is the appraisal technique used heavily in residential real estate, though is often used in commercial real estate valuation as well.
This method relies on looking at comps and recent sales data to help assign a value to the property in question.
Traditionally, the challenge with using the sales comp approach in commercial real estate was that finding comps could be difficult.
Sometimes, in order to find a comp, the appraiser may need to look well outside of the market area, which wouldn’t make for very reliable comparisons.
Demographics, leasing trends, access to infrastructure and more may look very different outside of the market area and all can have an impact on the value of the property.
With Reonomy real estate comps, however, finding a lengthy list of comps is now easier than ever.
To find comps using Reonomy, begin by running a property search for your target asset. That could mean searching for an asset type within a specific geographic delegation, or it could mean searching for a specific individual property.
See how to run a property search here.
Once you have identified the target property that you’d like to find comps for, simply click the “View Comparables” button present on the property’s profile page.
Upon clicking the icon, you’ll be given a list of comparable properties to that of your subject property.
From there, you can enter into any of your comparable properties, and view their sales history in the Sales tab of the profile page.
Reonomy real estate comps are based on many data points, only including factors that would equate to a very valuable comparison.
By analyzing the sales history of recently sold properties, you’ll be able to pinpoint a very accurate valuation of a commercial value of any asset type, in any market nationwide.
The Cost Approach
The “cost approach” calculates what it would cost to rebuild the property from scratch.
This accounts for the current cost of the land, construction materials, labor costs and more that would be associated with replacing the commercial property’s existing structure(s).
In short, this method assumes the value of the commercial property is equal to the cost incurred to re-construct it.
The cost approach uses a very simple formula:
- Property Value = Land Value + (Cost to Build New + Accumulated Depreciation)
This approach assumes that informed buyers would not spend more for a commercial property than they would be willing to spend on acquiring land and building the same property from scratch.
Costs to Build New can be calculated a number of ways:
- The comparative unit method calculates a lump-sum estimate for the costs to build new on a per square foot basis, looking at different categories of construction materials (e.g., steel frame vs. concrete frame, interior or exterior load bearing walls).
- The segregated cost method calculates the individual cost of various building components, such as the cost to build a new roof, the cost of new HVAC systems, and so forth.
- The unit-in-place method takes the segregated cost method to the next level by breaking down building components even further. For instance, it would analyze a roof not as a whole structure, but rather in terms of the individual pieces of the roof like joists and decking plates.
- The quantity survey method is generally considered the most accurate form of determining cost, but it’s also the most time-intensive method. The quantity survey method includes a detailed estimate for each building component and material down to the exact quantity needed to replicate the structure, and then adjusts for labor and other overhead accordingly.
Accumulated depreciation can be calculated using the straight-line method, which in commercial real estate, depreciates an asset equally over a 39-year period (per IRS guidelines).
An alternative way to calculate accumulated depreciation is by doing a cost-segregation study, which looks at the lifespan of individual building components, allowing depreciation to be front-loaded instead of equally over time.
The cost approach isn’t used very often, but it is most useful when a property is located in a less-than-active market where the data to feed the alternative approaches can be hard to come by.
The Income Approach
The income approach is the most frequently used appraisal technique when it comes to valuing a commercial real estate asset. The approach is based on how much income a property is expected to generate in the future.
In order to calculate the value using the income approach, you must first understand a few key commercial real estate concepts: net operating income (NOI) and capitalization rate (“cap rate”).
NOI is the net income generated by a property, less operating expenses but before capital expenditures, debt service and taxes. In other words:
- NOI = Effective Gross Income – Operating Expenses
The cap rate is a ratio of net operating income to a property’s value and is used to express an owner’s anticipated return on investment over the course of a year before factoring capital costs, debt service and taxes.
- Cap Rate = NOI / Value
Or otherwise stated: Value = NOI / Cap Rate.
To value commercial real estate in this way assumes the owner, or appraiser, has access to or can create a pro forma that shows the anticipated stabilized NOI.
A cap rate is then assigned to the equation.
In some markets, particularly more active commercial real estate markets like San Francisco and New York, most investors are accepting 3-4% cap rates at this point in the market cycle.
One of the pitfalls of this approach is that individual investors have a different tolerance for cap rate thresholds.
The benefit of this approach, though, is it allows an investor to determine what he might be willing to pay for a property.
For instance, assuming “X NOI / my acceptable cap rate,” I’m willing to pay Z for this asset.
The income approach is one of the most accurate valuation methods, but with a caveat: the inputs into calculating NOI must be highly accurate. If someone miscalculates rents or underestimates vacancy rates, for instance, the resulting numbers would be skewed.
The Gross Rent Multiplier Approach
The “gross rent multiplier (GRM)” approach is an alternative, simpler approach to valuing commercial real estate.
It’s really a back-of-the-envelope calculation that takes the price of the property and divides it by the gross income to estimate a potential valuation.
This is a quick and dirty way of identifying commercial real estate assets that have a low price compared to their market-based potential.
Here’s a simple GRM example.
- Property Value = Annual Gross Rents x Gross Rent Multiplier
$1,280,000 = $160,000 x 8 (GRM)
In this example, using a GRM of 8, a property that generates $160,000 per year in gross rental income would be valued at roughly $1.28 million.
The biggest difference between the income approach and the GRM approach is that the former uses the net income in its calculation of value, whereas the latter relies on gross income.
Valuation is Driven by Information
As you can see, there are multiple ways to value commercial property. Truth be told, an appraiser typically uses more than one approach and then takes an average of the approaches to determine the value of a property.
It’s important for any real estate investor or appraiser to understand the key inputs into these equations to truly understand the value of a property.
There’s a bit of a learning curve associated with appraisals, but each time you calculate a property’s value it gets easier.