The key differentiator between having a fruitful and a loss-making deal when acquiring, selling or investing in commercial property is knowing how much it is worth. Whether you are seeking to lease a retail shopping space or invest in an industrial park, you will automatically want to assess the value of the property to have a favorable return on investment.
Commercial real estate valuation is an intricate task, and the fact that each property is affected by its unique set of elements such as prevailing market rates and maintenance cost means that there is no one-size-fits-all when it comes to evaluations. With various variables to consider, how does an investor or owner price a commercial property?
There are three basic valuation methods often used to determine the value of a commercial property:
- Sales Comparison Approach
- Income Approach
- Cost Approach
Sales Comparison Approach
The sales comparison approach relates the value of a property to similar properties that are currently listed for sale or that have been sold historically. Realistically no two properties are identical so adjustments need to be made for the differences in the age, size, location, condition, building/land ratio, zoning, tax policies, date of sale, and other characteristics and conditions that would influence a property’s market valuation. Adjusting the comparables for each variance will allow you to select the values, giving greater weight to the comparables more similar to the subject property. The more similar, the more reliable they are considered. At the end of the day the sales comparison approach is the price a purchaser is willing to pay, and the seller is willing to sell for in an open competitive market.
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.
Income Approach
The income approach is applied on income producing properties and is based on the premise that a relationship exists between the income a property produces (future benefits) and its value. The net operating income that an investor can predict will be generated for the length of ownership would be considered the future benefits. Two methods used to determine value based on income are the direct capitalization method and the discounted cash flow model:
- Direct Capitalization Method: This method converts a one year stabilized net operating income (NOI) into a market value for the property. The formula is V = I/R. For example, if you know the NOI is $50,000 and the asking sales price or sold price is $500,000 then you know the Cap rate is 10%. Then you compare the cap rates of all the comparable properties.
- Discounted Cash Flow Model: This is a variation of the Cash Flow Model and used when uneven cash flows are anticipated. This model determines property value by discounting each years NOI and final sales proceeds to a present value (PV)
The most likely to purchase income producing properties are investors which is why the income approach is the best choice to value non owner – occupied properties.
Cost Approach
The cost approach calculates what it would cost to rebuild the property from scratch (minus accrued depreciation). This approach is based on the premise that a property’s value is influenced by the cost to produce a comparable property. The logic is that a rational and informed buyer would pay no more for an existing property than the cost to build a substitute property with the same utility.
The cost approach is used most often when sales comparison data is lacking, the property has not been built yet, or the it’s a special use property with few or no comparable sales.
The Bottom Line
Knowing the value of commercial property is important for several reasons. At the most basic level, the value tells you the most probable price the asset would sell for on the open market at present time. Additionally, the value of commercial property – both current and potential value – also helps investors and owners make strategic decisions about how to position the asset relative to the rest of their portfolio.
