Appraising commercial real estate poses a significant hurdle, more so when contrasted with the evaluation of residential properties. The challenge stems from more than just the complexity of valuation. It also comes from the array of techniques professionals employ to establish the value of commercial assets.
A precise property appraisal can act as a catalyst in unearthing potential deals that may have eluded other investors while simultaneously aiding in avoiding investments in overvalued properties. Here, we break down how to precisely determine your commercial property’s value and dissect key factors to consider during the appraisal process.
Why CRE Valuation is Important
Pinpointing the fair market value of commercial property is a critical step for investors and lenders. Investors in commercial real estate (CRE) leverage this calculation to settle on a purchasing price for properties listed for sale, identify opportunities that could augment the value of commercial real estate, and ascertain whether a property complements their real estate portfolio strategically.
For lenders, an estimator of commercial property value forms an integral component of the underwriting process. Typically, most CRE loans do not exceed a loan-to-value ratio (LTV) of 70%. The valuation of the property by the lender directly impacts the amount of the borrower’s down payment and the duration of the mortgage. Depending on various factors, it might also affect other terms and conditions of the loan.
Factors Affecting the Value of Commercial Property
The price tag attached to a piece of real estate doesn’t necessarily reflect its intrinsic value to a potential investor. The value is derived from the unique relationship between the prospective property and the opportunities it presents to the owner.
Generally speaking, four essential factors affect CRE valuation:
- Desire: Appeal that a specific property holds for an investor, often influenced by its location, amenities, and potential for profit.
- Utility: Functionality of the property and how well it can serve the purpose for which an investor is buying it.
- Scarcity: This denotes the availability of similar properties in the market; if a property type is rare or in high demand, it can significantly increase its value.
- Effective Purchasing Power: Measures an investor’s financial capacity to buy a property, which can impact its value, particularly in competitive markets.
The interplay of these factors is crucial in determining the value of a property. For instance, although a commercial property listed for sale may be unique and desirable, its value diminishes if it fails to fulfill the buyer’s objectives, like generating consistent rental income through leasing.
6 Ways to Determine Value of Commercial Real Estate
Assessing the value of commercial real estate can prove to be more complex than its residential or smaller multifamily rental counterparts. Let’s discuss six distinct methods that can aid in accurately determining the worth of a commercial property.
1. Sales comparison approach
Often referred to as the “market approach” or “pulling comps,” the sales comparison approach of commercial real estate valuation hinges on the recent transactions involving similar properties within the same market or submarket.
2. Cost approach
The cost approach, typically employed for unique properties or when comparable sales data is scarce, calculates the value of commercial real estate by considering the expense of constructing the property anew. This includes the present value of the land, material costs, and construction expenses.
3. Income capitalization approach
The income capitalization approach gauges the value of a property based on the net operating income (NOI) it generates in relation to similar properties in the same market. For instance, if retail properties in Nashville are trading at a cap rate of 5.5% and a comparable retail property is generating an NOI of $77,000 annually (before debt service), the income capitalization method would value the property at approximately $1,400,000 ($77,000 NOI / 5.5%).
4. Cost per rentable square foot
This approach to valuing commercial real estate involves subtracting the rentable square footage from the total square footage of a property and then comparing the resultant cost per rentable square foot to the average lease cost.
For instance, if a building with an asking price of $5 million encompasses 25,000 SF, with 4,000 SF allocated for common areas, the cost per rentable square foot would be approximately $227 ($5 million / 21,000 SF). An investor can then compare this cost per rentable square foot against the current market rent to forecast the potential gross rental income.
5. Cost per door
The cost-per-door approach provides a simple and fast way to compare the value of one apartment building to another. For instance, if a 40-unit apartment building is listed at $8 million, the cost per door would be $200,000. It’s important to note that this method does not consider aspects like unit size or the number of bedrooms in each unit.
6. Value per gross rent multiplier
Gross rent multiplier (GRM) is an uncomplicated method to compare one property with another and is a handy tool to narrow down purchase choices before carrying out in-depth due diligence. GRM can be computed by dividing the property’s purchase price by the gross annual rent.
For instance, if a property yields $400,000 in gross rental income annually and has a listed price of $6 million, the GRM would be 15 ($6 million / $400,000). The lower the GRM, the higher the potential a commercial property may possess, assuming all other factors are equal.
CRE Valuation Terms to Know
Before valuing a commercial property, it’s essential to familiarize yourself with various appraisal and valuation terminologies. These terms are crucial elements in understanding the process and calculations involved in commercial property valuation.
- Price per square foot: Calculated by dividing the property’s price by its total square footage. It’s a standard metric used to compare the value of different properties. However, it does not consider important factors such as property gross rental income, building age or class, unit types and quantity, or deferred maintenance.
- Net operating income (NOI): This is the annual income generated by a property after deducting all operational expenses, excluding debt service. It’s calculated by subtracting operating expenses from gross income.
- Cap rate (Capitalization Rate): A ratio that measures the rate of return on a real estate investment property. It’s calculated by dividing the NOI by the property’s current market value.
- Debt service Refers to the amount of money required over a period to repay the debt, including principal and interest.
- Gross rent: The total rental income a property would generate if it were fully leased at market rate; it can include income streams such as rent payments or payments for value-add items such as covered parking.
- Value: Refers to a property’s projected or current income stream, estimated through any of the six valuation techniques, which determines its potential selling price or worth.
- Cash on cash return: This calculation shows how much an investment will yield in a year, expressed as a percentage of the cash invested.
- Loan-to-value ratio (LTV): A financial term used by lenders to express the ratio of a loan to the value of the purchased property.
- Operating expense ratio (OER): Measurement of the cost to operate a piece of property compared to the income the property brings in.
The Bottom Line
Each broker, buyer, and seller has a unique approach to valuing commercial real estate. Assigning a value to your commercial property is a blend of art and science, factoring in measurable elements like square footage and less tangible elements such as potential for enhancing the value or repositioning the property.
Savvy commercial real estate investors leverage their business insight alongside precise data to identify and appraise the most profitable CRE opportunities across the nation.
Learn how to access Crexi’s more than 13 million sales comparables and property records through Intelligence.