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How Does Commercial Real Estate Valuation Work
By Adam Gower Ph.D.
Knowing how to value commercial real estate properly is probably the most significant factor in determining whether or not to include it in your investment portfolio. The ability to accurately evaluate acquisition properties and your own holdings is a skill that every serious commercial real estate investor must possess- you simply cannot succeed in this world without the ability to determine the market value of a property.
Whether you're an unseasoned greenhorn or an experienced investor with more than a few deals under your belt, a solid understanding of the best commercial real estate valuation methods is an essential ingredient for success in the world of real estate investments. I want to take a few minutes to give you an overview of the valuation process, as well as share some practical methods for creating commercial real estate valuations.
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Why Does Commercial Property Valuation Matter?
Property valuations matter for several equally important reasons. For buyers, an accurate valuation allows them to pick up a property at reasonable market value and ensures they do not overpay for an asset. Likewise, sellers use valuations to price their properties at a level where they can maximize their returns from the sale, as well as ensure the property moves in a timely fashion.
Valuation also comes into play when it comes to financing. Lenders and banks will only lend when the property is sufficiently valuable to act as collateral and can generate the necessary revenues to pay off the loan and deliver value to shareholders in the property.
Now, there are several methods that investors, real estate professionals, and finance professionals use to conduct property valuations- these methods are often situationally dependent based on the individual property's characteristics, like property type, location, intended use, etc.
Real Estate Appraisal Terms to Know
The cap rate is a property's net annual rental income, divided by the property's current value. Cap rates are used to represent the expected rate of return for a given commercial property.
Cost Per Unit
The cost per unit is the price of the property, divided by its total number of rental units.
Debt service refers to monies spent to cover the repayment of principal and interest on a debt within a given time period, i.e. annual, monthly, etc.
Gross Potential Rent
This is the amount of collectible rent from a multi-tenant property, assuming that all rents are paid in full and that the property in question is at maximum occupancy, with no units left unrented.
Gross rent is the total amount of rent stipulated in a commercial or residential lease, divided up among the months for which the tenant is responsible, gross rent may also be referred to as effective gross rent.
GRM (Gross Rent Multiplier)
If you take the sales price of a property and divide it by its annual gross potential rent, you come up with the gross rent multiplier. Cap rate is similar to GRM in that it represents a multiple to earnings, but a notable difference between the two is that the cap rate takes expenses into account, while GRM looks at the total inflow of rental income.
NOI (Net Operating Income)
NOI, or net operating income, is equivalent to the rental income of a property, minus any ownership related expenses, like maintenance, staff, etc.
Price Per Square Foot
To determine the price per square foot, you take the price of the property and divide it by the total square footage. This term is also colloquially referred to as the ‘price per pound’ of a building.
ROI (Return On Investment)
The ROI or return on investment is the cash flow that remains after debt service, which is then divided by the cost of the investment in question.
This term is shorthand for property-related expenses. It stands for "Taxes, Utilities, Management, Maintenance, and Insurance."
Vacancy and Collection Loss
When rental income is lost due to units going unrented or owed rents being uncollected, those are categories of vacancy and collection loss.
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Principles Guiding Valuation
In its basest terms, a property's value is defined as the current worth of potential future financial benefits measured by projected the sum of all net income streams that may arise from owning the property. In opposition to immediate consumable goods, like pencils, twinkies, and paint, which provide benefits immediately, real property assets tend to offer value over a more extended period- years or decades or longer.
This long timeframe requires that real estate investors and professionals must take into account prevailing political, social, and economic trends that may have an impact on the current and future performance of that real estate asset. These principles include:
Within the realm of commercial valuation, utility refers to the property's ability to fulfill the needs and desires of the future owner. This could be the revenues projected to be generated, or the utility of living in a property, like in your primary residence.
In a similar vein, demand refers to the needs or desires for ownership being present, along with the commensurate financial ability to execute a purchase of a commercial real estate asset.
Scarcity refers to the fact that commercial properties are finite, and how the abundance or scarcity of a property type in a given area will affect the price.
This term refers to how easy it is to transfer the ownership rights for a given property. For instance, if a large industrial facility has multiple owners that need to sign off on a sale, or unpaid liens, it will be inherently more complex to transfer than a property with a single owner, no liens, and no other investors/lenders involved.
How To Value Commercial Real Estate - The 5 Best Methods
There are multiple approaches used by investors to determine the value of a given commercial property. Let's take a look at a few of the most common and effective methods.
1. Cost Approach
The cost approach determines the value of a subject property as the price of the land plus the construction costs for erecting the building. For instance, if a 1-acre lot costs $100k, and building a retail center costs $1 million, the cost approach determines the value of that property at $1.1 million. This method assumes that the cost of a property is based on its optimal usage.
Let's say you own a property that has great potential for agricultural use, with fertile soil and clean running water. The cost approach would assume that the cost of that property should be based on agricultural use, rather than residential or shopping, since that would be the most productive and lucrative usage of the land.
This means that the cost approach is particularly susceptible to zoning laws and changes, which can substantially impact the allowed usage and potential cash flow and income generation potential of a property. Lenders often use a cost approach for new construction projects as a way to manage how funds are released as the project progresses through each individual phase. One downfall presented by this method is the fact that it does not take into account the income the property will create or the prices of similarly appointed comp properties.
2. Income Capitalization Approach
Income capitalization, or the income approach, is a valuation method that puts the expectation of future benefits first and foremost. The Income Approach determines value by taking into account the market rent that a property can reasonably be expected to generate, as well as the potential resale value of the property. Essentially, this method converts income into value by placing income as the primary determiner of value.
3. Sales Comparison Approach
The sales comparison approach, or market approach, uses recently sold comparable properties and asking prices of currently listed properties as data points to determine the current value of a similarly appointed property. This approach is commonly used in the multifamily and residential sectors, for instance, comparing two thirty-unit multifamily apartment buildings or two residential homes with similar characteristics and square footage.
The main benefits of this method come from the fact that it uses actual market data, which gives investors a snapshot of the realities on the ground in as close to real-time as you're going to get in the commercial real estate business.
Unfortunately, this approach does not work as well with unique or one-of-a-kind properties that have few nearby comparables. Additionally, this approach does not take into account vacancies, or losses from collections, or unforeseen repair or maintenance expenses, which can throw off its accuracy significantly in certain situations.
4. Value Per Gross Rent Multiplier
You can obtain the value using a gross rent multiplier in a manner somewhat similar to the income approach. Where these two methods differ is the fact that the rate used for the Gross Rent Multiplier approach is based on gross rent, whereas the income approach uses net operating income.
Calculating the Gross Rent Multiplier Approach goes like this:
Property Value= Annual Gross Rents x the Gross Rent Multiplier
For this calculation to be useful, it is essential to know the current Gross Rent Multiplier for nearby comparable properties. You can often find data relating to the GRM from real estate professionals, investor groups, and countless online resources. Let's look at an example. Say you have a property that is generating annual gross rents of $100k a year, with a Gross Rent Multiplier of 8.
You would multiply $100k by 8 and come up with a value of $800k. As this method does not use net income, it doesn't take into account expenses like repairs, maintenance, or losses sustained from vacant units or unpaid rent, eviction costs, and other costs of doing business. However, if you are looking for a simple valuation method to use in concert with other approaches, GRM is worth a look.
5. Value Per Door
Like the GRM, this method is fast and easy, although maybe not the most accurate compared to some of the other valuation approaches. This method takes the total value of a comparable building and divides that amount per door to come up with a point of reference for another comparable property.
For instance, let's say you find a 12-unit multifamily building with a value of $3 million. $3 million divided by 12 is 250k per door. You can then determine the value of another property with a different total amount of doors, say a 10 or 20 unit property. Simply multiply the number of doors with that per door value, so a 20 unit property would be $5 million-20 times $250k.
This method is only useful if you are using relatively equivalent comps, and it falls short by not taking into account apartment size and square footage differences, as well as the quality of the housing, and other ongoing costs associated with running a multifamily property.
Some forward-thinking real estate analysts and researchers have looked towards a new method, CAPM, or Capital Asset Pricing Model. This method aims to track the relationship between risk-adjusted returns and the larger market through the use of a variable called a beta.
This method can be used with many different types of investment assets, but in the real estate space, CAPM can be used to estimate the value of a commercial property by utilizing a beta that shares characteristics with the property. For instance looking at how well a publicly-traded real estate firm that is heavily invested in a certain geographic area is doing financially, which you can determine through their annual shareholder reports and other publicly available financial data. As this model is still in its infancy, it is not recommended for most investors at this time.
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Which Appraisal Method Is Right?
Imagine a master craftsman fashioning an elegant redwood table. While some skilled soul may be able to use a single tool to fashion a fine dining table, it doesn't make much sense. Most artisans will use all of the tools at their disposal to come up with the best result in their work. As an investor, you should follow the same principle. Some of these approaches are better based on the situation. For example, a property with lots of similar comps may fare better with the value per door approach, or a property in a hot market with lots of volume might be better served by the sales approach.
Remember to choose an approach that fits the situation and take the time to evaluate properties with multiple relevant approaches. You don't have to place equal importance on every method- use the one that is most relevant to the situation at hand.
Learning to properly value properties is perhaps the most powerful skill you can learn as a real estate investor. The ability to come to an accurate valuation opens up a world of opportunities and will help you identify diamonds in the rough, which you can acquire, rent, or resell- whatever you need to do to generate your ideal ROI.
Commercial real estate valuation also helps protect you from getting involved with loss-inducing properties, or overpriced assets, which may seem desirable until you get an understanding of the real costs associated with the acquisition and ownership of a subject property. If you take one thing away from this piece, it should be this: use a relevant/appropriate approach when evaluating commercial properties, and do not be afraid to use multiple methods to get the most accurate results.
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