7 commercial real estate valuation methods: How do they work?

What is commercial real estate valuation?

In the commercial real estate business, buyers want to keep the deal price as low as possible, while sellers want to do the opposite. The correct valuation process is essential to ensure that the transaction is fair to both parties.

You should remember that a host of factors go into determining the value of commercial property. Location, ease of transferability, the condition of the property, and several other attributes are essential to consider to arrive at the right valuation. It needs a mix of experience and theoretical knowledge to reach a sensible figure acceptable to both the buyer and seller. Additionally, the valuation methodology should assure all the parties affected that the exercise is objective and equitable.

Importance of accurate commercial real estate valuation

When a seller puts a property on the market, getting the offer price right is vital. A low figure will result in a commercial real estate deal that leaves money on the table. An inflated valuation, on the other hand, may attract no bids, delaying the sale process and forcing the seller to reduce the asking price. Accurate property valuation is equally important for buyers. If the purchaser pays more than the fair market value, it could jeopardize the transaction. Consequently, the property valuation must be arrived at as precisely as possible.

At this stage, we need to make a key point. There is no perfect valuation method or technique that will yield a magic number acceptable to everyone. Instead, there are several different approaches that can be adopted to arrive at a starting point for the price negotiation. For example, real estate investors could opt to value a property based on the net operating income that it generates. Or you could adopt a method that uses the price at which comparable properties in the area have sold recently.

This post will discuss seven different commercial real estate valuation methods. Each uses separate criteria to arrive at a property’s market value. How can you decide which one to use? That depends on the situation, the availability of the required information, and the specifics of the property in question. You can also use more than one method and calculate the average.

Common real estate valuation terms

Before we get into the different property valuation techniques, let us take a minute to understand some commonly used real estate valuation terms. Understanding these terms is vital to appreciate the nuances of the valuation methodologies we will subsequently discuss:

Cap rate

People commonly talk about the phrase “cap rate,” or capitalization rate, in real estate circles. Simply put, it is the annual return an investor can expect to earn.

Let’s understand this term with an example. A property’s net operating income (defined a few paragraphs below this point) is $100,000. And the price the seller is quoting is $1,000,000. The cap rate would be calculated as follows:

Cap rate = $100,000 / $1,000,000 = 10%

Notice that the cap rate is expressed as a percentage.

Debt service

Debt service refers to the funds you need to service a loan for a specific period. For instance, if you have taken a loan of $1,000,000 and you need to pay $50,000 in interest and repay $50,000 towards the principal every year, the debt service amount is $100,000 per year.

Gross rent multiplier (GRM)

The gross rent multiplier, or GRM, is a metric that tells you the ratio of a commercial property’s price to its annual gross rental income.

A property with an annual gross rental income of $100,000 and a price of $1,000,000 has a GRM of 10.

Net Operating Income (NOI)

The NOI of a property is the cash a commercial property yields after all expenses have been paid off.

Price per square foot

The price of a commercial property divided by its square footage gives you its price per square foot. It tells purchasers how much they are paying for a property in terms of square feet.

Return on Investment (ROI)

Return on investment or ROI is the profit you make on a property investment after all the expenses. Commercial real estate investors use this metric to determine their profitability on a transaction.

Let’s say you bought a commercial property for $1,500,000 and invested $500,000 for repairs. Your total cost works out to $2,000,000. Subsequently, you sell the property for $3,000,000. Your return on investment is:

Value

Value refers to the worth of a property. The word can also be understood as the present worth of the future monetary benefits the property will provide to the owner.

Factors to determine which commercial real estate valuation method to use

A closer look at the factors influencing valuations will be helpful at this stage. Understanding these factors can help you decide which valuation method to use for a particular property.

Factors	Description
Demand and supply	The availability of commercial real estate and the number of buyers in the market play a pivotal role in determining values. If demand exceeds supply, it will drive prices up. The situation will be reversed if supply is more than demand.
Utility	How will the property be used? Is it at a suitable location? If the layout of the property and its location satisfy the user’s needs, it could positively affect its valuation.
Scarcity	A commodity that is not readily available commands higher valuations, and a commercial real estate investment is no exception.
Transferability	A commercial property that is easy to transfer will typically have a higher purchase price than a property where the procedure for change of ownership is more complicated.
Cost vs. price vs. market value	The terms cost, price, and market value are sometimes used interchangeably, but they are distinctly different. “Cost” tells you about the money spent on acquiring and repairing a property. “Price” is the sum a buyer pays for a property. “Market value” refers to the perceived valuation and is the sum a seller would expect for a property.
Local market activity	A local market with limited real estate inventory and plenty of buyers will likely increase prices.
Local real estate activity	Local real estate activity refers to the number of deals in the immediate area. It’s easier to arrive at an accurate valuation if there are plenty of other transactions to compare a specific property with.
Market stability	Stable markets make for more accurate valuations. It’s far more difficult to arrive at a fair valuation in a market prone to alternate economic growth and contraction periods.

Commercial real estate valuation methods

Commercial real estate valuation methods are crucial for making informed decisions in this high-stakes market. They objectively assess a property’s worth, guiding investors towards profitable acquisitions, lenders towards responsible lending, and developers towards projects yielding optimal returns.

Accurate valuations also prevent financial miscalculations, safeguard against overpaying or under-pricing, and ultimately contribute to a healthy and stable real estate landscape. Now, let’s look at the seven different valuation methods:

Cost approach

As its name implies, the cost approach uses an estimate of the sum of money it would take to build a similar property.

It is possible to arrive at a more accurate valuation figure if the property value is reduced to account for the building’s depreciation. This cost approach is often used for unique properties. For example, this approach is a good choice if there are a limited number of similar properties in the area to compare the property’s value. The cost approach can also find application in an inactive property market.

Discounted cash flow

The discounted cash flow (DCF) method uses future cash flows from the property to arrive at a valuation. These are the primary cash outflows and inflows to consider:

Outflows	1. Cost of the property 2. Annual maintenance costs 3. Repairs, taxes, insurance, and other costs
Inflows	1. Rental income 2. Sum received from the sale of the property

It is important to remember that this method considers all the inflows and outflows connected with the property. An appropriate discount rate is applied to the flows to arrive at a net present value for each cash flow. The DCF method is most useful when it is possible to predict future cash flows with some degree of accuracy.

Sales comparison approach

The sales comparison method uses data from the sale of similar properties in the area to arrive at a valuation. Adjustments can be made to account for differences with the comparable properties. The sales comparison approach is an excellent choice if there are multiple transactions involving similar properties in the immediate area.

Income capitalization approach

The valuation of a property is arrived at by dividing the property’s NOI (net operating income) by a specific cap rate.

The income capitalization approach works best when the property has a predictable rental income stream.

Value per gross rent multiplier

The gross rent multiplier method of valuation is similar to the income approach. However, it uses gross rent and not NOI.

This method is a simplistic approach to valuation as it is based on gross rents. However, it can be useful when comparing two properties with similar attributes.

Value per door

The value per door methodology is typically used for residential real estate. However, it also finds application in commercial properties that have many similar units.

Cost per rentable square foot

This method involves dividing the property’s price by its square footage. When calculating the square footage, the cost per rentable square foot method requires that shared spaces like staircases and other common areas are included. The cost per rentable square foot valuation method can be a good choice when valuing premium commercial properties.

Challenges in commercial real estate valuation

Commercial real estate valuation is an inexact science. It’s practically impossible to arrive at a precise number that provides an absolutely accurate property value for a specific real estate asset. Why is that? You must keep in mind that each property is unique. Its location, what it is used for, the construction quality, the current economic situation, interest rates, and several other factors determine a commercial property’s value. So, is it possible to overcome these challenges to arrive at an accurate valuation?

The answer to this question is a qualified “yes.” If the valuation is to be accurate, it should use reliable data. Additionally, the assumptions made should be realistic. For example, when estimating future rental inflows, it is prudent to be conservative and take an average of rents for similar properties in the vicinity.

How to choose the right commercial real estate valuation approach?

The choice of valuation method depends mainly on the availability of data as well as the nature of the property. One of the best options is the discounted cash flow method, which considers projected cash flows from the investment. However, the DCF method may only be a good choice if data regarding future rentals can be wholly relied upon.

The sales comparison approach is another excellent choice if there has been an adequate number of transactions involving comparable properties in the area in the recent past. In many instances, a final figure is reached by taking the average of the valuations arrived at by two or more of the methods described above.

The bottom line

You should keep two key points in mind when valuing a commercial property. The first is that a valuation’s accuracy ultimately depends on the reliability of the underlying data and the validity of the assumptions used in the valuation process. Secondly, regardless of the research and effort that goes into the valuation, the figure you arrive at is, at best, an estimate of the property’s current worth.

While understanding valuation methods is crucial, remember that they are just tools. The true journey lies in navigating the nuances of each property and market. Accurately assessing a commercial property’s worth goes beyond formulas and spreadsheets. It demands a meticulous blend of data analysis, insightful assumptions, and a keen awareness of market trends.

Modified Date & Time : 19 Apr 2024, 03:32 pm