In commercial real estate, there are various types of “value” given to real property, all of which serve different purposes to different people.
When conducting any type of analysis on a property, its value is always going to be taken largely into consideration.
In this article, we’ll take a look at the difference between an asset’s market value and its investment value.
Market Value vs. Investment Value in CRE
The different types of “value” in commercial real estate include:
- Market value
- Investment value
- Insurable value
- Assessed value
- Liquidation value
- Replacement value
Sometimes, the lines between these value types can be a little blurred, especially when considering market and investment value specifically.
The types of real estate value can be defined as follows.
Types of Real Estate Value
1. Market Value
Market value, or “fair” market value, is the most commonly referred-to property value type, and is the value used in the loan underwriting process.
The Appraisal Institute’s “Market Value: What Does it Really Mean” provides a historical overview of “value” and “market value,” including many definitions from a variety of sources.
One example comes by way of the Federal Deposit Insurance Corporation (FDIC), stating that market value is, “the most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale.”
In other words, what is a buyer willing to pay, and a seller willing to accept, given that all other circumstances are standard and expected.
2. Investment Value
Investment value is the value that a property offers to a specific investor. It is the value that the investor would be willing to pay for the property.
Regardless of market value, there’s always going to be a limit to what an investor is willing to sink into an asset.
Investment value is based on the investor’s own qualifications, available capital, tax rate, and financing.
3. Insurable Value
This refers to how much of a property is at potential risk of damage, for the sake of determining insurance coverage.
In other words, what is the value of the portion of the property that can be covered in an insurance policy.
4. Assessed Value
Assessed value is a property value determined by a local tax assessor for real estate tax purposes.
5. Liquidation Value
Liquidation value establishes the likely price that a property would sell for during a forced sale, such as a foreclosure or tax sale.
Liquidation value is used in times where there is a limited window for market exposure, or whether there are other restrictive sale conditions in place.
6. Replacement Value
This is the cost to replace the structure with an identical substitute structure, that has the same utility as the original property.
Now, a commercial property can have any of the above types of value determined at any time.
And it’s very possible that none of the values are the same (though it is likely that at least some of them are close).
That is especially true when considering the difference between market value and investment value—just because a property should garner a certain amount, that does not mean that an investor will offer anything near it.
Moreover, what’s perceived as “valuable” to a specific market, might not be valuable to an investor.
With definitions of each in mind, let’s look at the different approaches for both market and investment value, to show their differences more granularly.
Approaches to Market Value
Market value is what’s being determined during an appraisal.
During the loan underwriting process, many lenders will look to a third-party appraiser in order to get a market value estimate for a property.
Market value is what’s used to determine an appropriate mortgage amount.
So then, how do appraisers actually determine market value?
There are actually many ways. But, before any of that takes place, the highest use of the property must be distinguished.
Essentially, what needs to be determined is the legal use of a property that yields the most value—so think about things like zoning, property uses, property sizes, financial return, and so on.
In short, what is the potential “ceiling” of the property and its entire parcel?
Once that is all set in stone, an appraiser can move ahead with a property valuation.
Generally, there are three valuation approaches that appraisers use to determine the fair market value of a commercial asset:
1. The Sales Approach:
The sales approach gets you a property value by looking at other recent sales of very comparable assets.
2. The Income Capitalization Approach:
The income based approach simply derives a property value from the income that it generates.
3. The Cost Approach
This approach bases a property’s value on the cost of reproducing that property, minus any accrued depreciation.
Approaches to Investment Value
While the market value process is used in appraisals for loan underwriting, when deciding how much to pay for a property, investors also consider how much a property is worth to them.
Investment value is the amount that an investor is willing to pay, with respect to their objectives, target yield, and tax position.
So, as market value is always unique to a market, investment value is unique to the investor at-hand.
With that, comes a number of other approaches that can be used to determine value, unlike the more formal valuations required by appraisers.
The following are the most common measures of investment valuation:
1. Comparable Sales (Comps):
This is essentially the same as the sales comparison approach mentioned above.
2. Gross Rent Multiplier (GRM)
This is a ratio that measures value by taking the gross rents a property produces throughout the year, and multiplying it by the market-based Gross Rent Multiplier.
3. Cash on Cash Return
The cash on cash return is another simple ratio, calculated by taking the first year’s pro-forma cash flow (before tax), and dividing it by the total cost of initial investment.
4. Direct Capitalization
This is the same direct capitalization approach mentioned above that is used by appraisers. Capitalizing the income stream of a property is a very common and simple way to determine both market and investment value for a commercial property.
5. Discounted Cash Flow
The discounted cash flow model is used to find the internal rate of return (IRR), net present value, and a capital accumulation comparison.
So then, knowing the different approaches to generating these values, let’s give some tangibility to how these to types of values differ from one another.
Market Value vs. Investment Value
To recap, market value is the value of a property in an open market, determined by an appraisal.
Investment value is determined by the actual investor based on their unique investment goals and criteria.
Below, we’ll illustrate an example:
Suppose an individual investor is contemplating the acquisition of a small apartment building.
The property is under contract for $1.2 million, and is looking for a minimum 10% return on the asset.
Based on the investor’s target yield, they could pay up to $1.4 million and still meet their goal.
In this scenario, the investor finds that they can obtain a $960,000 loan (80% loan to value), amortized over 20 years at 5%.
Now, suppose that during the underwriting process, the bank’s third-party appraisal values the property at $1,000,000 rather than the $1.2 million the buyer is locked into.
That valuation would reduce the supportable loan amount to $800,000 (based on a LTV of 80%), rather than the previously anticipated $960,000.
Unfortunately, though, in this scenario, the seller refuses to sell for less than $1,200,000.
That would make this an above market transaction, which simply means that the sale price is higher than the property’s current market value.
Does it still make sense for the investor to follow through with this deal , then?
The new loan amount would reduce the yield from 22% to 16%, but that still exceeds the investor’s goal of a 10% return.
In most cases, the market and investment values should be roughly the same, but they will occasionally diverge.
Furthermore, it is also very possible that investment value is higher than market value.
This can happen when the value to one buyer is higher than the value to the average, well-informed buyer.
For example, say a company expands to a new building across the street from their current location, paying more than market value in order to grow nearby and fill space that’d otherwise be filled by competitors.
In chasing a strategic advantage, the value is a little higher to them—the extra cost can be justified.
In the case of an investor, investment value could exceed market value as a result of favorable financing terms or non-transferable tax treatment.
Investment value, of course, can also be lower than market value.
Maybe an investor is looking at an office building, but specializes in multifamily real estate.
To them, an office building is going to have a lower investment value due to the learning curve and other incremental costs involved.
Another scenario where investment value could be lower than market value is if an investor requires an above-average return based off of the return from their existing portfolio.
Finding Deals that Make Sense
All in all, for anyone individual real estate deal, it depends.
The circumstances will vary drastically.
Generally, the safest play is to make sure an investment makes sense in terms of both value measures.
Investment value is more subjective, and therefore should not be abused—but it should be taken into consideration.
Likewise, market value should never be your end-all.
Estimate market value yourself before investing in anything, and pair that with third-party market values and investment values.
If the seller promotes an investment value that’s much higher than market value, make sure to dig and prove that that’s the case.
The combination of these value types allows commercial real estate buyers to understand their investments more holistically, and creates a more fair market for all involved.