When you’re getting started in commercial real estate investing, it can be confusing trying to understand how property values are determined. There are a handful of different methodologies, and each comes with its own set of merits and drawbacks. Some valuation methods are good for quick analysis of a property when first determining potential investments, while other valuation methods are solid for landing on a fair offering price.
In this article, we’ll cover some of the most common methods of commercial property valuation, along with some of the terms most frequently used in this realm of finance. With this information, you’ll be better equipped to analyze your own investment deals and understand how funds make decisions about the properties they add to their portfolios. Let’s get started!
The Income Capitalization valuation method is the most commonly used method for determining property value in commercial real estate deals. In this valuation method, the property’s income is estimated using the capitalization rate, usually referred to as simply the “cap rate.”
To find the cap rate, the net operating income of the property is divided by its current market value (or sales price). For example, on a property that has a Net Operating Income (or NOI) of $500,000, we would divide this figure by the cap rate (9%) to arrive at a valuation of $5,555,556.
Often called The Cost Approach, this method is a more complicated way to determine the value of commercial real estate.
First, the value of the land a building sits on is determined. Next, the costs of building an exact replica of the current structure are added to the land value.
Next, the depreciation factor is determined and used to adjust the combined values to provide the final value.
Also known as the Sales Comparison Approach or the Comparable Approach, the Market Value Approach to property valuation is probably the simplest method of determining the value of a piece of commercial real estate.
First, a range of values is established from market research based on properties similar in use and size that have recently been sold in the surrounding area. Next, the value is adjusted based on the physical characteristics of the property being valued.
Essentially, this method of valuation seeks to determine what a purchaser is likely willing to pay in the current market environment.
This method of property valuation is based on the amount of income an investor can expect to earn from a particular piece of real estate. The income figure is usually derived in part from a comparison of other similar local properties, as well as any expected changes in maintenance costs.
Because the income projection is for the future, the expected income figure is discounted to the present value to determine the property’s price.
The Gross Rent Multiplier (GRM) valuation method helps determine a commercial property’s value by taking the cost of the property and dividing it by its gross income. This method of finding commercial real estate values is generally used to find properties with a low price relative to their potential income production for an investor.
For example, if you purchase a commercial property for $400,000 and it produces $60,000 in gross rental income per year, the GRM would be about 6.67 ($400,000 / $60,000).
The value per door method of commercial real estate valuation is used mainly for apartment buildings and not single-unit properties. Essentially, the value per door method determines the entire property’s value based on the number of units.
For example, an apartment building with 40 apartments priced at $4 million would be valued at $100,000 per door, no matter what each unit’s size or amenities are. This is a fairly rough method for quick approximate reads on value because it doesn’t account for the various qualities of each rental unit.
With the cost per rentable square foot valuation method, the size of the entire property is used to determine value, including not only the rental unit square footage but also the common areas such as stairwells, elevators, courtyards, and exercise rooms.
Once the total rentable square footage is determined, it’s used to find the cost per rentable square foot so it can be compared to the average lease cost per square foot for a comprehensive examination of the property’s value.
For example, if a property has 20,000 rentable square feet and the average cost to rent per square foot is $11 per square foot annually, a sales price of $2.8 million will generate nearly an 8% gross rental yield. If you know the property can fetch $13 per square foot annually in rental income, a valuation of $3.3 million will still yield you the same gross return rate.
The cap rate is calculated by dividing a property's net annual rental income by its current value. Cap rates help investors forecast their expected rate of return on the purchase of a commercial property.
For multi-unit commercial property, the cost per unit is found by dividing the sales price by its total number of rental units.
Debt service is the costs associated with real estate loans, including the principal and interest during a given time period.
Gross rent is the total rent price that’s stipulated in a tenant’s lease agreement, divided by the number of months that the tenant is responsible for. This number doesn’t account for any costs.
Net operating income, also called NOI, is the rental income of a property minus any expenses involved with ownership, such as maintenance, property staff labor costs, etc.
The price per square foot of a property is found by taking the price of the property and dividing it by the total square footage.
This term is an acronym for the typical expenses on a piece of property. TUMMI is short for "Taxes, Utilities, Management, Maintenance, and Insurance."
If the rental income on a commercial property is lost due to units remaining vacant or rents going uncollected, these are called vacancy and collection losses.
When you’re looking for ways to diversify your portfolio while increasing passive income, commercial real estate investing is a great place to start. If you’re not a fan of the idea of calculating byzantine numbers on every property you invest in, Saint Investment Group can help.
Saint Investment Group provides access to investing in exceptional commercial properties for investors that want solid returns and stable income streams without the need to be involved with the properties directly. You’ll have access to monitor fund performance through detailed monthly reporting and deal transparency so you can enjoy earning passive real estate income with peace of mind. Call (323) 483-0291 today to learn more about getting started.