Valuing Commercial Property: What You Need to Know
Effectively valuing commercial property is an art with more than one way to achieve results! Whether you’re seeking to buy or sell, consider this your comprehensive guide to choosing the approach that works best for you and your particular investment. Across this strategic summary we’ll cover a variety of nuanced evaluation methods and formulas for you to consider:
- The Cost Approach
- The Sales Comparison Approach (aka Market Approach)
- The Income Approach
- The Gross Rent Multiplier Approach
- Replacement Costs
- Valuation per Door
- Cost per Rentable Square Foot
- The Market
Now, here's how to accurately estimate commercial property value:
The Cost Approach:
Determine the cost to rebuild the structure
Typically applied when appropriate comparables are slim, this valuation approach considers what it would take to rebuild the retail property from the ground up—from the value of the land on which the building exists to the cost of constructing an exact reproduction of the building, plus any associated costs. Finally, depreciation value is considered and the property value number amended accordingly.
New Construction Costs - (Acquisition Cost + Renovations) = Delta
This delta represents your potential profit. If the delta is positive, consider flipping the property for a profit or renting it out at market rates. If the delta is negative, the investment opportunity is less promising.
Frequently utilized alongside sales comps, the cost approach method allows you to determine if a building is worth buying or if it makes more sense to construct a new one.
When to use: When the property includes specialized improvements and/or unusual features that add significant value to the underlying land.
The Sales Comparison Approach (aka Market Approach)
Carefully compare similar assets
Like residential properties, commercial real estate can be valued utilizing comparable properties. Look at recently sold buildings with similar elements from the same market area to help determine fair market value for your retail property in an open and competitive market.
Compare by factors like:
Type of construction
Land to building ratio
Local tax policies
Start by comparing prices per square foot, then adjust the value based on various aspects of each site.
Price per Square Foot x Square Footage = Property Value
$100 / sq. ft. x 10,000 sq. ft. = $1,000,000
When to use: When recent sales data for comparable properties is readily available or when an asset is generally vacant, so the lack of income doesn't add value.
The Income Approach
What kind of income can you expect as an investor?
You can use the cashflow a property generates to estimate fair market value. Calculate by dividing the net operating income by the capitalization rate (aka cap rate).
Net Operating Income / Cap Rate = Property Value
The cap rate is determined by dividing a property's net operating income by the current market value. Lowering the cap rate generally increases the estimated value.
When using the income approach, pay close attention to the condition of the property, operating efficiency, and vacancy.
For example: For a commercial property with a gross potential income of $500,000, subtract a 10% vacancy factor of $50,000 and you have an effective gross income of $450,000. Deducting the property's operating expenses will reveal a Net Operating Income (NOI) of $300,000. Now divide that by the cap rate (8%) and you've determined fair market value with a price of $3,750,000.
Source: Stirling Properties, LLC
Not sure how to project income to start with? Compare similar local properties! Consider lower maintenance costs from decreasing inefficiencies or passing water usage and electric costs to tenants. Keep in mind, all expected future income is discounted to reflect present value.
When to use: A popular strategy, rely on the income approach to value any commercial property with rent-paying tenants from apartments and hotels to shopping centers and office buildings.
The Gross Rent Multiplier Approach
Divide the total purchase price by gross rents.
Measure and compare a property’s potential valuation by dividing the total purchase price by its gross income.
Total Purchase Price / Gross Rent = Gross Rent Multiplier
This ratio is known as the Gross Rent Multiplier (GRM) and will reveal how many years it would take to pay off a commercial property based on the gross rent received. The lower the number, the better the investment opportunity. For example:
$100,000 total purchase price divided by $10,000 in gross rent = 10 GRM
Based on the GRM in this case, expect the property to pay for itself in 10 years.
You can also use the inverse of this method to determine an investor’s value of the property. So, if you want a property to pay for itself in 10 years, you'd multiply that property's gross revenues by a GRM of 10.
Note that various investors apply different GRMs when evaluating assets, so this number is considered more subjective—which is why you won't see the approach exercised as often as sales comps or cap rates.
When to use: When considering properties with a low price relative to its potential income.
More commercial valuation approaches include…
Value Per Door
Generally best for calculating the value of apartment buildings more so than single-unit structures, this approach determines worth based on the number of units in the building.
For example: A building with 10 apartments priced at $5 million would be valued at $500,000 “per door” regardless of unit size.
Cost Per Rentable Square Foot
Rentable square footage includes the space tenants can occupy (usable square footage) along with shared areas they benefit from like elevators and stairwells. Using this approach, you can extrapolate the cost per rentable square foot and compare it to the average lease cost per square foot to estimate commercial property value.
For example: If a building has 10,000 rentable square feet and the average cost to rent per square foot is $12 per square foot annually, a purchase price of $1.7 million will generate 7% gross rental yield. However, if you know you can charge rent of $14 per square foot annually, a valuation of $1.9 million will yield the same gross return.
Source: First Republic Bank
Ultimately, value is determined by the market. Property is only worth what a buyer is willing to pay for it. That’s why you’ll find some commercial properties sell for more or less than what you feel they're actually worth. Timing the market to your advantage matters.
Real Estate Valuation Challenges
Commercial appraisals are typically more subjective than residential reviews and can be based on uncontrollable elements like the availability of similar local comps, the current market price for which spaces rent, and varying maintenance costs that may shift drastically by industry. But don't be discouraged—we're here to help! Having a team of commercial real estate experts in your corner makes all the difference.
Which Valuation Approach is Right For Me?
Now that you're more familiar with how to find the value of property, you might be wondering which valuation method aligns with your commercial real estate needs. Access to data and the availability of similar local comps impacts which method will work best—as does the location, building size, type, and a myriad of other factors! Estimating commercial property value is a blend of science, strategy, seasoned experience, and intuition.
If you're not sure how to most accurately value commercial property, know that Verada is here to help!
Verada empowers you to earn more and stress less. A one-stop-shop that leverages the latest technology to service commercial real estate landlords and retail tenants, our next-generation commercial retail listing platform and broker services are tailored to meet your every need.
Verada was founded to address inefficiencies in the commercial retail marketplace. By integrating technology and data analysis with best-in-class property presentations, we effectively drive interest and lead clients to commercial retail spaces, providing landlords and tenants with optimized results.
Connect now to discover how our team is prepared to ensure you achieve your most ambitious commercial real estate goals.
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