Valuing commercial real estate property isn’t just about crunching numbers. It’s about uncovering the return potential of every deal. This makes commercial real estate valuations an essential skill for real estate investors.
Understanding commercial property valuation
A commercial building’s value is whatever price a buyer and seller ultimately agree on. However, there are different commercial property valuation methods that can help you estimate that price.
Why commercial property valuation matters
Commercial real estate valuations are what drive investment returns.
For example, if your valuation suggests a commercial property is worth $10 million, and you’re able to get in under contract for $9 million, you’ve locked in $1 million in potential profit.
Similarly, if you turn around and sell the commercial property worth $10 million for $12 million, you’ve locked in an additional $2 million in profit.
Ultimately, it’s common knowledge to buy low and sell high. But in order to know what “low” and “high” are, you must first have an accurate valuation to reference. Then, you can find profitable commercial real estate investment strategies.
Other areas where commercial property valuations are necessary include tax assessments, mortgage approvals, and commercial real estate liquidity strategies.
Essential factors influencing property value
Here’s what goes into a commercial property’s value:
- Location, infrastructure, and market accessibility. The closer a property is to transportation, businesses, and amenities, the higher its value. The same goes for proximity to customers, employees, and planned infrastructure.
- Building age and condition. With the exception of buildings that gain in historical value, most structures deteriorate from wear and tear over time. The older the building and the worse it’s been maintained, the less valuable it is and the costlier the repairs.
- Market supply and demand dynamics. Basic economics also impacts property values. Higher supply puts downward pressure on prices, while higher demand puts upward pressure on prices (and vice versa). This includes demand from rental tenants.
- Legal considerations and zoning regulations. A property’s permitted uses and restrictions can significantly impact its value. For example, restrictive zoning, easements, and other commercial real estate regulations can lower its value.
- Energy efficiency and sustainability standards. Property owners and tenants increasingly value sustainable building designs and energy efficiency. As a result, properties certified by LEED or that meet ESG standards may be more valuable.
- Rental income potential and lease structures. Current rental rates, lease terms (e.g., triple net vs. gross), and the quality of existing tenants can all affect a property’s value. The same goes for any rent escalation clauses or potential vacancy risk.
The property appraisal process
Here’s what’s involved in preparing for and conducting an appraisal:
Necessary documents and financial records
Before conducting or commissioning an appraisal, gather any documents that could shed light on the commercial property’s value and condition. These could include the property’s:
- Title report
- Tax history
- Rent roll
- Lease agreements
- Maintenance logs
- Utility bills
- Other historical records
Selecting a qualified appraiser
If you hire an appraiser, select a qualified candidate for the job. Look for a licensed professional with appropriate credentials, such as an MAI or ASA designation.
From there, ensure they have experience appraising similar properties in your market and ask for a sample report. Also, check online reviews or request references to ensure they have a positive track record.
Overview of the appraisal process
Once you’ve hired an appraiser, it’s time for a commercial property inspection. This can reveal structural issues, needed repairs, and the building’s overall condition.
From there, the financial and legal documents you gathered can be reviewed for further insights into the property’s income potential and zoning and use options.
With a clear understanding of the property’s condition, financials, and legal restrictions/uses, the appraiser can deliver a final commercial real estate valuation report that also explains its methodology.
Post-appraisal steps and considerations
Once you have the appraisal, carefully review it to ensure it’s accurate and complete. If you notice any mistakes, request a correction. If you still have doubts or it’s a high-stakes decision, get a second opinion.
You can use the appraisal to make competitive purchase offers, negotiate on price, and qualify for financing. However, you must update the valuation periodically to reflect market shifts.
How to value commercial property: Core methods
You can use any of the following commercial real estate valuation methods:
Cost approach
The replacement cost approach, or cost approach, involves adding the land value and the cost to build the commercial building and then subtracting any depreciation.
This is great when comparable properties (aka comps) aren’t readily available, or the commercial property has unique features that significantly impact its value.
Income capitalization approach
The income capitalization approach, or income approach, is the most common commercial real estate valuation method. It involves dividing the property’s current or projected net operating income (NOI) by a capitalization rate, or cap rate.
Net operating income refers to gross rental income minus operating expenses, while cap rate is a property’s annual rate of return based on its income. Typically, the cap rate used in this approach is based on the average cap rate for the market or nearby comps.
Sales comparison approach
The sales comparison approach uses recent sales data of similar nearby properties to estimate value, with adjustments made for differences in age, condition, size, etc.
The comps’ average price per square foot (PSF) is then multiplied by the subject property’s square footage to arrive at an estimated value.
Discounted cash flow (DCF) analysis
A discounted cash flow (DCF) analysis projects future cash flows and discounts them back to a present value (PV).
One of the major benefits of this approach is that it factors in the time value of money. It’s ideal for long-term investments with complex cash flows, such as a development project.
Residual land value method
The residual land value method helps you value development land by subtracting development costs from the potential sale value.
For example, if the development costs are $5 million and you expect to sell the property for $8 million, the residual land value would be $3 million. This is how much you could pay for the land to break even on the project.
Gross rent multiplier (GRM)
The gross rent multiplier (GRM) method estimates commercial property value based on its gross income.
First, you determine the gross rent multiplier based on nearby comps. For example, if a property sold for $1 million and generates $100,000 in gross annual rent, you’d divide the former by the latter to arrive at a GRM of 10.
Do the same GRM calculation for other comps and average the results. Then multiply the subject property’s current or expected gross rent by the GRM.
Price per square foot analysis
Price per square foot analysis is a quick way to estimate a property’s value by multiplying a building’s square footage by an average price per square foot. It’s often used to value office and retail properties.
For example, if an office has 20,000 square feet (SF) and the market’s average price per square foot is $200, the property would be worth $4 million (20,000 SF x $200).
Per unit or per door valuation
A per unit or per door valuation is similar to a price per square foot analysis. However, instead of estimating value based on an average PSF price, you base it on an average price per unit or door. This method is mainly used for multifamily real estate.
For example, if an apartment building has 100 units and the market’s average price per unit is $200,000, the property would be worth $20 million (100 units x $200,000).
How to avoid common property valuation pitfalls
Now that you know different valuation methods, here are some common mistakes to avoid:
- Relying on outdated or incomplete market data. These can skew your valuations, so always ensure you’re working with the most current and complete comps and datasets.
- Neglecting ongoing operational expenses. When using income valuation methods, don’t forget to factor in any ongoing expenses like property taxes or maintenance costs.
- Misapplying valuation models. Use the appropriate valuation method for the property type and cross-valuate with other methods for the most accurate results.
- Overlooking market fluctuations. Monitor interest rates, economic cycles, and changes in supply and demand so you can adjust your valuations accordingly.
- Ignoring legal or environmental issues. Unresolved zoning, title, or environmental issues can drastically reduce a property’s value, so always do your due diligence.
Leveraging technology in property valuation
These days, many tools can help streamline the valuation process.
Leverage real estate data analytics tools
Data analytics tools can help you identify patterns in commercial real estate values to spot opportunities. For example, if you notice a particularly hot market with rising commercial property values, now could be a good time to buy and lock in future equity gains.
Employ GIS mapping for location analysis
Geographic information system (GIS) maps can help you visualize demographics, traffic patterns, and zoning overlays to identify optimal property locations for specific uses.
Use automated valuation models (AVMs)
Automated valuation models (AVMs) can generate quick, algorithm-based property valuations to give you a starting point from which to refine your valuations. That way, you don’t have to conduct a full appraisal on every property lead.
Leverage CRM systems for investor relations
With the right investor CRM system, you can seamlessly update limited partners (LPs) on commercial property valuations, promoting accountability and transparency.
Impact of emerging trends on property valuation
Here are some emerging CRE trends that may impact commercial property valuations moving forward:
- Rise of mixed-use and flexible spaces. Hybrid work has increased demand for versatile spaces, thereby boosting the value of these property types.
- Incorporating ESG (Environmental, Social, Governance) factors. Tenants and customers are prioritizing the environment, putting a premium on sustainable buildings.
- Influence of remote work on commercial space demand. With the rise of remote work, demand for office space is falling, putting downward pressure on values.
Conclusion
Accurate commercial property valuation is essential to making smart investment decisions. By understanding the factors that influence value, you can better assess opportunities and risks. Whether you’re using the income approach, sales comparison, or discounted cash flow analysis, choosing the right valuation technique for the situation is key. Ultimately, it’s all about using the right methods and keeping a pulse on the market to spot opportunities others miss.
