Commercial real estate valuation presents a unique challenge compared 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 is crucial for identifying overlooked deals and avoiding overpriced investments. In this article, we will explore the different factors affecting commercial property value and provide you with six ways to determine the value of commercial real estate.
Why Commercial Real Estate Valuation Matters
Determining the fair market value of commercial property is essential for both investors and lenders. For investors, commercial property value helps determine the purchase price of real estate, evaluate potential value-add opportunities, and assess its fit in a real estate portfolio. Lenders, on the other hand, use property valuation to determine the borrower's down payment, mortgage length, and other loan terms and conditions.
Factors Affecting the Value of Commercial Property
The value of a commercial property is determined by four essential factors: desire, utility, scarcity, and effective purchasing power. These factors must complement each other for a property to have value. For example, a type of commercial property may be scarce, but if it doesn't fulfill the buyer's needs, it will have minimum value.
6 Ways to Determine Value of Commercial Real Estate
Compared to residential properties, valuing commercial real estate can be more complex. Here are six methods commonly used to determine the value of commercial property:
1. Sales Comparison Approach
Also known as "pulling comps" or the "market approach," the sales comparison approach relies on recent sales of similar properties in the same market or submarket.
2. Cost Approach
The cost approach is used for special use properties or when sales comparables are difficult to find. It determines the value by considering the cost of building the property from the ground up, including the land's value, materials, and construction costs.
3. Income Capitalization Approach
The income capitalization method uses the net operating income (NOI) a property generates to determine its value. It compares the property's income to similar properties in the market.
4. Cost per Rentable Square Foot
This method subtracts the rentable square footage from the total square footage of a property and compares the cost per rentable square foot to the average lease cost. It helps project potential gross rental income.
5. Cost per Door
The cost per door method compares the value of one apartment building to another based on the number of units. It is a quick and easy way to compare properties.
6. Value per Gross Rent Multiplier
The gross rent multiplier (GRM) is a simple way to compare different properties. It is calculated by dividing the property purchase price by the gross annual rent. A lower GRM indicates more potential for a commercial property.
Essential CRE Valuation Terms
Before determining the value of a commercial property, it is important to understand some key terms:
- Price per square foot: Calculated by dividing the property asking price by the square footage, but it doesn't consider factors such as rental income or building condition.
- Net operating income (NOI): The property's annual income after subtracting operating expenses, excluding debt service.
- Cap rate: The annual net operating income (NOI) divided by the property value, used to forecast the potential rate of return.
- Debt service: Repayment of principal and interest on the mortgage used to purchase the property.
- Gross rent: The total income generated by a commercial property, including rent payments and other income streams.
- Value: The estimated worth or selling price of a property based on its income stream or other valuation methods.
Determining the value of commercial property is a blend of art and science. Experienced investors combine data with their business acumen to locate and value the best commercial real estate deals. By understanding the factors affecting value and using various valuation methods, you can make informed investment decisions.