There is an old adage that something is only worth what someone is willing to pay for it. In the world of commercial real estate investment, this is also true … mostly. A property’s value is only worth what a buyer is willing to pay for it. But, there are a number of industry standard methodologies used to approximate the value of a commercial property based on a number of factors. In other words, value is not totally subjective. The result of these calculations can be used as a starting point in the price negotiations between buyer and seller in a commercial real estate deal.
In this article, we describe different valuation methodologies for commercial real estate. Once finished readers will have a good idea of the drivers of commercial real estate value and the approaches used to calculate it.
In our own due diligence at FNRP, we utilize all approaches to valuation to ensure we pay a favorable price. To learn more about our current property offerings, click here.
Why Does Commercial Property Value Matter?
Very simply, the price paid for a commercial real estate property may be the single biggest driver of investment returns in a commercial real estate transaction. It matters most in two places: the purchase and the sale.
During the purchase phase of a transaction, a commercial property can be an excellent investment opportunity in all regards, but it can be difficult for a real estate investor to meet their return objectives if they pay too much to acquire it. So, getting the property value right in the purchase phase is a critical first step towards making a healthy profit. As such, buyers are incentivized to pay as little as possible in a purchase.
When it comes time to sell the property, sellers are motivated to get as much as they possibly can for it. This is because the profit that results from the difference between the purchase price and the sales price is one of the largest components of investment returns on commercial property.
In both cases, real estate property values – and the methodologies used to calculate them – matter because an owner wants to do everything they possibly can to maximize their return.
What Affects Commercial Property Value?
Before diving into the specific valuation methodologies, it is important to understand what aspects of a commercial property drive its value. In commercial real estate, there are several of note.
When a comparable property in the same market sells, it creates a “comp” in the valuation process. So, to some extent, the value of a given commercial property is a function of the recent sales of similar properties that surround it.
A property’s “Cap Rate” is the return an investor could expect if they purchased it in all cash. It is calculated by dividing a property’s Net Operating Income (NOI) by the proposed purchase price or current value. In some ways, a cap rate is a representation of the market’s perceived risk in the property. The lower it is, the less risk the market assigns to the asset. Conversely, the higher it is, the more risk that a market assigns to a property, which means an investor will pay less to acquire it.
In fast growing markets where rents are rising, older buildings are at risk of being usurped by newer, more technologically advanced properties that rent for the same price. For this reason, it is critically important to be aware of replacement costs, which is how much it would cost to “replace” a property. If it can be done profitably given market rents, it is a safe bet that new competitors will enter the market.
Market conditions drive rental rates, which in turn drives the value of the property. So, markets with limited supply and strong demand are a good indication that rental rates have a potential to rise and/or cap rates have the potential to fall.
The more useful a property is, the more in demand it is going to be. So, properties that have an excellent location and serve a valuable purpose to a community – like a bank or grocery store – will likely be more valuable than those with a poor location and no useful purpose.
Supply & Demand
This is a subset of market conditions, but supply and demand impact a property’s rental rates, which ultimately impact its value. This can be seen by looking at two opposite ends of the same spectrum. On one end, if a market has a limited supply of rental space and strong demand, it would drive rental prices up, which is a positive for commercial real estate investors. On the other end, if a market has plenty of supply, but no demand, this will drive rental rates and property valuations down, which is a negative for investors.
If a certain property type, in a certain market has a high level of demand, then it can be easier to sell (more transferable) than a property type that has no demand. In many cases, investors are willing to pay a premium for a highly transferable property versus one that would be more difficult to sell.
With these factors in mind, there are 4 commonly used approaches used to value a commercial property.
How to Value Commercial Real Estate: 4 Methods
To be clear, commercial real estate valuation is both a science and an art. It is a science in the sense that there are commonly used valuation methods and techniques to approximate the fair market value of a property. But, it is also an art in the sense that there are a number of assumptions that go into each of these calculations and they could vary from one investor (or analyst) to another. And, at the end of the day, a property is worth whatever price a buyer and seller can agree upon to exchange it.
With this in mind, detail on the commonly used valuation approaches is provided below.
1. Cost Approach to Valuation
The logic behind the cost approach to valuation is that a rational buyer would not pay more for a property than it would cost them to build a similar property from the ground up. The formula used to calculate the value of a commercial property using the cost approach is:
Property Value = Replacement Cost – Depreciation + Land Value
The Replacement cost can be estimated using the replacement method, which estimates the cost of constructing a building with the same level of utility as the one being valued. Or, it can be estimated using the reproduction method, which estimates the cost of constructing an exact duplicate of the property being valued using the same materials and construction methods.
Depreciation refers to the gradual decrease in the value of a property due to physical deterioration over time.
Finally, the value of the land is estimated using the direct comparison method. With this method, the current value of the land is derived from recent sales of comparable parcels.
The Cost Approach is used in both residential and commercial property valuations, but tends to be more prevalent in residential transactions.
2. Income Approach
The “income capitalization approach” – sometimes called the “direct capitalization approach” is the most commonly used commercial valuation approach. Using this method, the value of a property is calculated by taking its net operating income and dividing it by a chosen “capitalization rate.” The equation looks like this:
Property Value = Net Operating Income / Capitalization Rate
Net Operating Income is calculated as a property’s gross rental income minus its operating expenses. More often than not, the cap rate is chosen based on the cap rates for recent sales of comparable properties.
While this approach to value appears to be very simple, the logic behind it can be complex. The calculation of NOI depends on a series of assumptions about rental growth rates, occupancy levels, market conditions, cost growth, and repairs and maintenance to be performed. Often, these assumptions have to be made about things that won’t happen for several years. This is where the “art” of valuation comes into play. The assumptions need to be conservative and supported by market data.
3. Sales Comparison Approach
The logic behind the sales comparison approach is that the value of a property is derived from recent sales of comparable properties in the same market. To find comparable properties, appraisers consider the size, condition, location, and amenities of a property and make adjustments to arrive at a value or price per square foot.
Again, the sales comparison approach is very common in residential real estate. While it is used in commercial transactions, it isn’t as heavily relied upon.
4. GRM Approach
The “Gross Rent Multiplier” is a metric used by commercial real estate professionals to approximate a property’s value based on the amount of gross rental income it produces. Using this approach, the value of an investment property is calculated in two steps.
In the first step, the Gross Rent Multiplier is calculated for recent sales of similar properties. The formula used to calculate it is:
Gross Rent Multiplier = Sales Price / Annual Gross Rents
Once the GRM is calculated for comparable properties, it can be applied to the estimated gross rents of property being valued. For example, if the GRM for comparable properties was calculated to be 10 and the gross income of a property was $500,000, the value could be reasonably estimated at $5,000,000.
Summary & Conclusions
Valuing a commercial property is both an art and a science. It is an art in the sense that it requires a series of assumptions and estimates. It is a science in that there are several commonly used valuation methodologies and they must be followed to assign a level of credibility to a valuation estimate.
The value for commercial rental properties is driven by a variety of factors including market supply and demand, utility of the property, how easily transferable it is, and the potential cost to replace it.
The most commonly used approaches used to determine the current market value of a property are the cost approach, income approach, sales comparison approach, and Gross Rent Multiplier.
While all of these approaches are widely accepted and based on data, at the end of the day a property’s true value is whatever price the buyer and seller agree upon. Often, it is very close to the results obtained by one or more of these approaches.