Investors have it easy when determining the value of a residential real estate property. To calculate the value of the asset you are reviewing, log into Zillow or go to the MLS.
Analyzing commercial realty, however, is more complicated.
The most critical factor in deciding whether to include commercial real estate in your investment portfolio is knowing how to value it correctly. A skill that every serious investor in commercial real estate must have is the ability to value acquisition properties as well as your holdings accurately. You won't be able to succeed in this market without determining the property's market value.
It doesn't matter if you are a novice investor or an experienced one. However, having a solid knowledge of commercial real estate valuation techniques is essential for your success in real estate investing. So let me give you a brief overview of the valuation process and share some practical tips for creating commercial real-estate valuations.
Why is Commercial Property Valuation Important?
Valuation of property is essential for many reasons. A property valuation is critical for buyers because it allows them to purchase a property at a reasonable market price and not overpay. Sellers also use valuations to determine the value of their property and ensure that it moves quickly.
When financing is involved, valuation also plays a role. Banks and lenders will only lend if the property is sufficient to serve as collateral. They also need to generate enough revenue to pay the loan off and return value to the shareholders.
There are many methods investors, finance professionals, and real estate professionals can use to value property. However, these methods are often situationally dependent, depending on each property's unique characteristics (e.g., property type, location, intended uses, etc.
Principles Guiding Valuation
The property's current value is the potential financial benefits derived from the property. This sum includes projected net income streams. Tangible property assets offer a longer-term return than immediate consumable goods like paint, pencils, Twinkies, and paint. They can provide benefits over years, decades, or even decades.
The utility is used in commercial valuation to describe the property's ability to meet the future owner's needs. For example, this could refer to the revenue projected to be generated or the utility of living at a property like your primary residence.
Similar to demand, it refers to the need or desire to own a commercial property and the financial ability to purchase the asset.
Scarcity refers to the fact that commercial property is finite and affects the price.
This refers to the ease of transferring ownership rights to a property. For example, it is more difficult to transfer ownership rights to extensive industrial facilities with multiple owners or unpaid liens.
The 5 Best Methods to Value Commercial Real Estate
Investors can use a variety of approaches to determine the market value of commercial properties. Let's look at some of the most popular and efficient methods to assess the value of a commercial property.
The cost approach is the sum of the land price and the building costs. This determines the property's value. For example, if a 1-acre parcel costs $100k and a retail center costs $1million, the cost approach calculates the property's value at $1.1million. This assumes that the property's optimal use determines its cost.
Let's suppose you have a property with great potential for agriculture. It has fertile soil and running water. Cost analysis would suggest that the property's cost should be determined based on agricultural uses and not residential or commercial, as this would be the land's most lucrative and productive use.
Income Capitalization Approach
Income capitalization or the income approach is valuing a property that considers future benefits. The Income Approach calculates the value of a property by considering the expected market rent and potential resale values. This method transforms income into value by making income the primary determinant of value.
Sales Comparison Approach
The market approach to sales comparison uses comparable properties that have been sold recently and the asking prices of properties currently on the market as data points to calculate the current value for a property with similar amenities. This method is used frequently in multifamily and residential areas. For example, it compares two multifamily apartments with thirty units or two homes with similar square footage and characteristics.
This method has the main advantage of using actual market data. Investors get a real-time snapshot of real-world realities in the same time frame as commercial real estate.
This approach is ineffective for unique properties or those with few comparable. In addition, this approach doesn't account for vacancies, losses from collections, and unforeseen repair or maintenance costs, which can make it inaccurate in certain circumstances.
Value per Gross Rent Multiplier
A gross rent multiplier can be used to calculate the value in a somewhat similar way to the income method. The only difference between the two approaches is that the Gross Rent Multiplier method uses gross rent and the income approach uses net operating income.
The following is how to calculate the Gross Rent Multiplier Approach:
Property Value = Annual Gross Rents x Gross Rent Multiplier.
To make this helpful calculation, it is essential to know the Gross Rent Multiplier of nearby properties. Real estate professionals, investor groups, and countless other online resources can often provide data on the GRM. Let's take an example. Imagine owning a property that generates annual gross rents of $100k per year. With a Gross Rent Multiplier (or 8.)
Multiply $100k by 8, and you get $800k. This method doesn't use net income and does not consider expenses such as repairs, maintenance, losses from vacant units, unpaid rent, evictions, and other costs associated with running a business. GRM can be used with other methods if you're looking for an easy way to value your property.
Value per Door
This method, like the GRM, is quick and straightforward, but it may not be as accurate as some other valuation methods. This method divides the total value of comparable buildings by the amount per door to create a point-of-reference for another similar property.
Let's take, for example, a 12-unit multifamily property with a $3 million value. Divided by 12, $3 million equals 250k per door. The value of another property with a different number of entries can be calculated, such as a property with 10 or 20 units. Multiply the number of doors by the value per door. A 20-unit property would then be worth $5 million-20 million.
This method can only be used if the comps are comparable. It does not consider differences in apartment sizes and square footage, as well as the quality of housing and ongoing costs associated with managing multifamily properties.
Forward-thinking real property analysts and researchers are looking at CAPM (Capital Asset Pricing Model). The beta variable is used to track the relationship between the risk-adjusted returns of the market and the greater market.
This method can be used for many types of investment assets. However, in the real-estate space, CAPM can also estimate the value of commercial properties by using a beta that shares characteristics. You can see how a publicly-traded real estate company with a significant investment in a particular area is doing financially by looking through their annual shareholder reports. This model is still very infancy and is not recommended by most investors.
Which appraisal method is right?
Imagine a skilled craftsman creating a beautiful redwood table. It may seem simple for an experienced person to use one tool to make a beautiful dining table. However, to achieve the best results, artisans will use every tool they have. Investors should also follow this principle. Some approaches work better depending on the circumstances. For example, a property with similar comps might do better with the value-per-door process. Conversely, a property in a hot market with high volume may be better served with the sales approach.
Prices for Replacement
Some investors purchase assets based only on the replacement cost.
This method is often used in conjunction with sales reps. It helps investors determine if the building's worth buying or whether they should build a new one.
These buildings will frequently require some renovation. This will be included in the calculation.
You will need to calculate the total cost of building a new home or purchasing land to use this method properly.
New Construction Costs minus (Acquisition Cost plus Renovations) = Delta
$170 / sq. ft. less ($80/sq. ft. plus $25 / sq. ft.) = $65 / sq. ft. Delta
This indicates the potential profit the investor can make from this scenario.
If the delta in the equation is positive, you could either rent the property out at the market rate or flip it. The delta should be positive to ensure you don't lose the deal.
Markets ultimately determine the price of commercial property.
Even if you calculate the property's worth based on market cap rates, recent sales comps, or other methods, it is only what a buyer is willing to pay for it.
It's because of this that you might see properties sell at a higher price than you believe they are worth. Timing is everything in the acquisition and disposition process.
The most important skill you can acquire as a real estate investor is to value properties accurately. You can identify potential opportunities by being able to value properties accurately. This will allow you to acquire, rent or resell them, whatever you need, to maximize your return on investment.