Commercial real estate valuation presents a challenge, especially in comparison to residential real estate. Not only is it difficult to value, but there are also several methods professionals use to determine commercial property value. An accurate property value can help identify deals that other investors have overlooked and avoid investing in overpriced property.
Why CRE Valuation is Important
Determining the fair market value of commercial property is essential for investors and lenders. CRE investors calculate commercial property value to determine a purchase price of real estate for sale, evaluate potential commercial real estate value add opportunities, and decide if a property is a strategic fit in a real estate portfolio.
Lenders use a commercial property value estimator as part of the underwriting process. On average, most CRE loans have a maximum loan-to-value ratio (LTV) of 70%. A lender’s property valuation determines the size of the borrower’s down payment and the mortgage’s length. Depending on several factors, it may also influence other loan terms and conditions.
Factors Affecting the Value of Commercial Property
There’s a difference between the cost of real estate and the value a specific property has to an investor. That’s because the value is the relationship between the property desired and the potential it offers to the owner.
Generally speaking, four essential factors affect CRE valuation:
- Effective purchasing power
All of these factors must complement each other for a property to have value. For example, even though a type of for-sale commercial property may be scarce, it will have minimum value if its utility to fulfill the buyer’s needs – such as generating rental income via a lease – can’t be achieved.
6 Ways to Determine Value of Commercial Real Estate
Compared to houses and smaller multifamily rental properties, commercial real estate can be much more complicated to value. Here are six commercial property valuation examples to help determine the value of commercial property.
1. Sales comparison approach
Also known as “pulling comps” or the “market approach,” the sales comparison approach for valuing commercial real estate relies on recent sales of similar property in the same market or submarket.
2. Cost approach
Often used for special use property or when sales comparables are difficult to find, the cost approach determines CRE value by considering the cost of building the property from the ground up, including the land’s current value, materials, and construction costs.
3. Income capitalization approach
The income capitalization method uses the net operating income (NOI) a property generates to determine the property value compared to similar properties in the same market. For example, if office buildings in Houston are trading at a 7.9% cap rate and a similar office property is generating an NOI of $500,000 per year (before debt service), the income capitalization approach would value the building at $6,329,114 ($500,000 NOI / 7.9%).
4. Cost per rentable square foot
This method for determining the value of commercial real estate subtracts the rentable square footage from a property’s total square footage, then compares the cost per rentable square foot to the average lease cost. If an office building with an asking price of $7 million has a total of 30,000 SF with 5,000 SF used for common areas, the cost per rentable square foot would be $280 ($7 million / 25,000 SF). An investor can then compare the cost per rentable square foot to the market rent to project the potential gross rental income.
5. Cost per door
The cost per door method quickly and easily compares one apartment building’s value to another. For example, if an apartment building with 30 units is priced at $6 million, the cost per door is $200,000. Note that this method does not consider factors such as unit size or the number of bedrooms per unit.
6. Value per gross rent multiplier
Gross rent multiplier (GRM) is another simple way to compare one property to another and is a useful tool to narrow down purchase options before conducting more thorough due diligence. To calculate GRM, simply divide the property purchase price by the gross annual rent. If a property generates $300,000 in gross rental income each year and is priced at $4.5 million, the GRM would be 15 ($4.5 million / $300,000). The lower the GRM is, the more potential a commercial property may have, everything else being equal.
CRE Valuation Terms to Know
There are several valuation terms to know and understand before you can determine the value of a commercial property. Some of the most common appraisal and valuation terms include:
- Price per square foot is calculated by dividing the property asking price by the square footage but does not take into account important factors such as property gross rental income, building age or class, unit types and quantity, or deferred maintenance.
- Net operating income (NOI) subtracts normal operating expenses – excluded debt service – from the property’s annual income.
- Cap rate is calculated by dividing the annual net operating income (NOI) by the property value. CRE professionals use cap rates to forecast the potential rate of return on an asset.
- Debt service is the repayment of principal and interest on the mortgage used to purchase a commercial property and is typically expressed on an annual basis.
- Gross rent is the total income generated by a commercial property and can include income streams such as rent payments or payments for value-add items such as covered parking.
- Value is the estimated worth or selling price of a property’s current or projected income stream using one of the six valuation methods.
Every buyer and seller appraises commercial real estate differently. Determining your commercial property value is a mixture of art and science, considering both tangible components such as square footage and intangible aspects such as value add or potential for repositioning the property. The most experienced commercial real estate investors combine their business acumen with accurate data to locate and value the best CRE deals from coast to coast.