Six Practical Methods to Value Commercial Real Estate

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Trying to come up with the right value of a commercial real estate asset can often feel like steering a ship through stormy seas. When all variables are static, using any of of the valuation methods is quite simple. The challenge is that variables are ever shifting and typically a combination of valuation methods need to be considered in order to come to an accurate figure. With so many factors influencing a property's value - from current market rental prices to replacement costs, and even the subjective willingness of a buyer - estimating an accurate worth is no easy task.

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Whether you're considering an industrial complex, a retail shopping center, or an apartment building, it's crucial to understand the different valuation methods available and when to use them.

Cost Approach

The cost approach to commercial property valuation starts with a rather somber question: What would it cost to rebuild this structure from scratch? This technique isn't just about bricks and mortar; it also factors in the current land value and the various costs associated with replacing the existing structure.

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Imagine a historical building with intricate architecture and unique features; traditional comparables wouldn't suffice to estimate its worth. In such cases, the cost approach serves as a practical method, particularly if the structure contributes significantly to the land's value.

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This is a method we use a lot to discuss the big picture of our portfolio strategy. Given the current market conditions, are we able to acquire existing assets below replacement cost, or is it more feasible to develop new assets?

Sales Comparison Approach

Often dubbed the "market approach," the sales comparison technique hinges on recent sales data from similar properties. In essence, it tries to gauge the property's worth by comparing it to its recently sold peers.

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Consider a 20-unit apartment building in a bustling neighborhood. A similar property sold in the same area a few months back could offer an accurate estimate of the current building's value. However, market dynamics could make finding an exact match difficult, making this approach more challenging.

Income Capitalization Approach

The income approach is a method that many investors are familiar with. The income capitalization approach weighs the expected income an investor can generate from the property against the current market cap rate. An appropriate market cap rate can be derived from other recently sold properties by taking the annual net operating income (NOI) and dividing that by the properties sale price. Doing this for a set of similar properties will generate a reasonable cap rate to use.

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For instance, suppose a building is producing $140,000 in annual NOI and similar properties in the area are trading at a 7% cap rate. If you take the NOI ($140,000) and divide by the market cap rate (7%), you come to a property value of $2,000,000.

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Value = Net Operating Income / Capitalization Rate

$2,000,000 = $140,000 / 7%

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This forecast could be adjusted by factoring in efficiency improvements or cost-saving measures like passing some utility costs to tenants.

Gross Rent Multiplier Method

The Gross Rent Multiplier (GRM) is a simple but effective way to assess a property's value. It involves dividing the property price by its gross annual income. For example, if a commercial property costs $600,000 and generates $80,000 in gross rents annually, the GRM would be 7.5.

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GRM = Purchase Price / Gross Rental Income

7.5 = $600,000 / $80,000

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This valuation formula is generally used to identify properties with a low price relative to their market-based potential income.

Value per Door

Primarily used for multi-unit properties like apartment buildings, the value per door method bases the property's worth on the number of units it houses. For example, a building with 30 apartments priced at $6 million would have a value of $200,000 "per door."

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This approach simplifies the valuation process, especially for large complexes, though it might overlook the variable sizes and conditions of individual units.

Cost per Rentable Square Foot

In commercial real estate, not all square footage is created equal. The cost per rentable square foot approach combines the usable square footage (the actual space tenants can occupy) with shared common areas, like hallways and elevators.

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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.

Conclusion

Valuing commercial property is as much an art as it is a science, each investor applying their instincts and expertise to these methodologies. Through these varied approaches, investors can harness a comprehensive understanding of their potential purchase.

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