Property valuation is an important piece of the commercial real estate transaction puzzle. But how exactly does it work?
There are many elements at play when it comes to commercial real estate valuation, each of which depend upon specific property characteristics, property history, data points, and external market conditions. In this post, we’ll take a look at the property metrics that matter most, along with the three most common methods that appraisers use in determining CRE property value.
Why is Property Valuation important?
The value of a property is simply the more probably price at which a property should bring in, in a competitive and open market with buyer and seller each acting prudently and knowledgeably, assuming price is not affected by undue stimulus.
As an investor, value is related to the specific purpose for which you have purchased a property. Essentially, the investor is trading their investment dollars for the property’s income. The value is determined by the net operating income divided by the desired return. Income properties should produce a cash flow that covers all expenses but also reduces the debt necessary to acquire the property as well as provides a return on your investment.
The Metrics that Matter
A property’s estimated value takes into consideration a variety of key data points, in addition to current market conditions and political and social trends. The four primary elements of property value are as follows:
- Demand: the desire or need for ownership supported by the financial means to satisfy the desire.
- Utility: the ability to satisfy future owners’ desires and needs.
- Scarcity: the finite supply of competing properties.
- Transferability: the ease with which property ownership rights are transferred.
An accurate appraisal depends on the methodical collection of the commercial real estate data points that influence these elements and characterize a particular property. Metrics of particular importance include capitalization rate, net operating income (NOI), rental rate, lease terms, TI allowance, and rent escalations, each of which play a key role in the appraisal methods outlined below.
The Methods Appraisers Use
There are three commercially recognized valuation models for real estate: the income approach (cash flows), the sales comparison approach (comparable market analysis), and the cost approach. The method or methods commercial real estate appraisers employ to determine a property’s value varies depending on the type of property in question. Each approach has its advantages, and when used together, the various methods give you the best idea what the property you are analyzing is worth.
The income approach is the primary method used to appraise income-producing properties like multifamily apartment complexes, office buildings, and retail centers. While this approach is considered to be the most meaningful and accurate gauge of CRE property value, it is also the most complex. The two principle methods are Direct Capitalization, based on one year of income, and Discounted Cash Flow, based on multiple-year projection period and reversionary value. The only properties that this approach cannot be used with is for-sale real estate investment like condos, single family or land development.
The first step in using the income approach is to determine a property’s NOI, or the revenue that a property generates minus necessary operating expenses. Determining NOI is often an exceedingly detailed process in which an appraiser creates an entire profit and loss statement for a property, factoring in details like projected maintenance expenses and vacancy rates over an extended period of time.
Simply, the process for calculating a Pro Forma or NOI is a projection of cash flow. This is used to determine value using common investment ratios and eventually a discounted cash flow analysis.
In creating the cash flow analysis, there is a specific format that is followed:
Gross Scheduled Income: The sum of the expected rent for a particular property. In an apartment building, it would be the sum of rents from each unit.
Vacancy and Collection Loss: Vacancy is calculated as rent loss due to empty units. When underwriting, the lenders usually use 5% or the market vacancy factor.
Effective Gross Income: This is the difference between the gross scheduled income and the vacancy factor.
Operating Expenses: Includes things like taxes, utilities, management, maintenance, insurance. Any expenses that are necessary for normal building operations. Whether these expenses are handled by the tenant or the owner are often decided by the lease.
Net Operating Income (NOI): This is the difference between effective gross income and the operating expenses.
Once the NOI has been assessed, the appraiser will survey other similar-earning properties in the same area to determine the current market value of the property in question. Capitalization rate can then be calculated by dividing the NOI by the determined market value. The capitalization rate is a complex term, but very simply it is the ratio of net operating income to a property’s value and represents a return on investment in a given year before accounting for capital costs, amortization, depreciation, taxes etc.
Finally, the appraiser divides the property’s NOI by its cap rate to arrive at a value estimate.
The simple steps are:
- Calculate the Net Operating Income
- Determine the appropriate Capitalization Rate
- Divide the Net Operating Income by the Cap Rate to arrive at an estimated value
Because it takes into account so many essential metrics, the income approach is largely regarded as the most valuable and information-dense CRE appraisal method. But for the same reason, this method requires close attention to detail, as an incorrect assessment of any factor can dramatically alter the resulting valuation. While steps are simple, it can be difficult to determine the right NOI and the most appropriate cap rate.
Although the income approach is generally perceived as the most comprehensive gauge of a property’s value, other approaches can be used to great effect in specific circumstances.
Sales Comparison Method
The sales comparison approach, sometimes called the market data approach, is a way to determine market value by comparing a particular property to properties with the same or similar characteristics. This method is typically required if the investor is seeking conventional financing. Commercial real estate appraisers using this approach must select comparable properties, ideally sold within the last year and within the same market considerations, and take into account seemingly both major and minor considerations. This includes basic things like area and square footage, along with more nuanced aspects like quality of construction and property conditions. Location also has a big effect on the property’s market value.
Qualities that adjust comparable sale prices:
- Age and condition of buildings
- Terms and conditions of sale (such as seller under duress)
- Date of Sale
- Physical features such as lot size, landscaping, construction quality, number of rooms, lot size, etc.
Accurately determining like properties and accounting for differences requires extensive research, knowledge of an area, as well as industry experience. The appraisal process often analyzes at least 3 or 4 comparable properties. The resulting valuation reflects the idea that a property’s value is worth the net value of all of its features, which can be helpful for particular kinds of property — for instance, a multi-condo property. More frequently, the sales comparison method is used for residential properties.
Appraisers can also use the cost approach method by evaluating the costs of creating a property exactly like the subject. This approach operates on the assumption that a reasonable buyer would not pay more for an existing property than it would cost to buy a comparable lot and construct a new building. This approach combines the use of real commodity values with the market comparable values of the land. The method involves separate estimates of the value of the building and the land and considers depreciation. This approach is useful when dealing with infrequently sold properties that do not produce income — i.e., schools, churches, hospitals, and government buildings.
Building costs can be estimated in several ways, including the square-foot method where the cost per square foot of a recently built comparable is multiplied by the number of square feet in the subject building; the unit-in-place method, where costs are estimated based on the construction cost per unit of measure of the individual building components, including labor and materials; and the quantity-survey method, which estimates the quantities of raw materials that will be needed to replace the subject building, along with the current price of the materials and associated installation costs.
Depreciation of value, for appraisal purposes, takes into consideration physical deterioration (painting, roof replacement, structural problems), design features that are no longer desirable, and economic degeneration (external to the property e.g. close to a noisy highway).
The least frequently used of the three appraisal methods, the cost approach requires an in-depth knowledge of construction and material costs. Accurate real estate valuation is important to lenders, investors, buyers and sellers of real estate. While appraisals are generally performed by skilled professionaly, anyone involved in real estate transaction should have a basic understanding of the different methods of valuation.
CRE appraisal is complicated, and requires years of experience to fully master. When it comes to determining the value of commercial property, CRE data platforms like Reonomy present an invaluable time-saving opportunity by offering instant access to key property metrics like capitalization rate and sale history. See for yourself — start a free trial of Reonomy National today.