There is an old adage that something is only worth what someone is willing to pay for it. In the real estate industry, this is only partially true. There is always a price that an investor is willing to pay, but it may or may not be close to the “fair market value” of the property. This idea begs the question, how is fair market value determined?
The most frequent method used to determine fair market value is to commission a real estate appraisal. An appraisal is a valuation estimate that is completed by an impartial third party expert. Appraisers spend years studying standard valuation techniques and their conclusion has a major impact on the final sales price and loan amount in a transaction. Despite similar uses for commercial and residential properties, the valuation methods that the appraiser uses for each is very different. They are the subject of this article.
How are Commercial Properties Valued?
Simply, commercial properties are valued based on the amount of Net Operating Income (NOI) they produce.
Net Operating Income is calculated as a property’s gross income less its operating expenses. While the calculation is relatively simple, there are a number of factors that influence each of the variables in this equation.
On the income side, the appraiser will review the following data points to determine a property’s potential rental income:
- Existing leases and their rental rates
- Rental rates for comparable properties within the same market
- Market rental yields
- Property square footage
- Vacancy level for similar properties in the same market
- Onsite parking and the parking space per square foot ratio
- Proximity to local transportation links such as buses, subways, trains, and major highways
- Property type
- Macroeconomic conditions both in the present and in the future
Using this information, the appraiser can begin the process of putting together the income forecast for the property that they are evaluating. But, this is only half of the equation, they also need to estimate the property’s operating expenses. To do so, they consider factors such as:
- The property’s historical operating expenses
- Maximum allowable depreciation
- Known operating expenses for similar properties in the same market
- Best practices for each expense category. For example, an appraiser may know that the property management expense should be “X” percent of gross income.
- Macroeconomic conditions both in the present and in the future.
With expenses estimated, the last steps are to calculate Net Operating Income (NOI) and choose a capitalization rate (cap rate). The choice of a cap rate in real estate may be one of the most important decisions that an appraiser will make and it is usually based on the cap rate achieved in recent sales of comparable properties in the same market. Net Operating Income is divided by the cap rate to determine the value. For example, if an apartment building is determined to have NOI of $500,000 and the cap rate is 7%, the estimated value would be $7.14M.
The methodology described above is commonly referred to as the “income capitalization approach” and it is the most frequently used commercial real estate valuation technique. But, it isn’t the only one. The Cost Approach explores how much it would cost to build the property from scratch, the Sales Comparison approach looks at comparable sales for similar properties, and the Gross Rent Multiplier (GRM) approach looks at the price of the property and divides it by estimated Gross Income. An appraiser may use one or more of the above approaches to make a final estimate of the current market value.
With regard to commercial property valuation, the important point is this. Final values are based on Net Operating Income and the value can be “forced” to appreciate when certain levers are pulled by the real estate investor. This does not happen with residential real estate investment.
Residential Real Estate Valuation
The process for valuing a residential property is much more simplistic. The value of the property is determined by using the sales comparison approach.
With this approach, the appraiser reviews all elements of the residential property including the: square footage, finishes, year constructed, landscaping, neighborhood, and condition. Then, they identify several other properties within close proximity that have recently sold. The “comparable properties” or “comps” should be as similar to the subject property as possible. But, this isn’t always possible. If there are some differences, it may be necessary for the appraiser to make a series of “price adjustments.” For example, one of the comps may have a pool, but the subject property doesn’t. As such, it is necessary to adjust the value of the subject property down to reflect this.
Once the adjustments are complete, the average sales price is calculated for the comps on a per square foot basis and this value is applied to the subject property. For example, assume that the subject property is 2,000 SF and the average price PSF for the comps is $200. At this rate, it could be assumed that the subject property is valued at $400,000 on the open market.
If the appraisal is commissioned as part of a purchase and the value is materially different from the purchase price, this could present issues for the viability of the transaction. As such, it is important for real estate agents and brokers to have a detailed understanding of the residential valuation methodology to price their properties accurately.
With regard to residential property valuation, the key point is that comparable sales are what drive prices. These cannot be changed by active management of the property.
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