How To Value Commercial Real Estate | Commercial vs. Residential Real Estate

It is essential to know the value of a property before you buy or sell it. In an open, active, and competitive market, value is the most possible price the property could earn in a fair and knowledgeable transaction between buyer and seller.

Commercial real estate valuation is a combination of science and art, but there are a number of methods at your disposal. Commercial vs. residential real estate is fairly different. The added complexity and heightened value make the valuation process much more difficult for the former.

3 Approaches to Value Commercial Real Estate

Commercial real estate investment is a highly lucrative endeavor. It is typically appraised in three different ways, and selecting the right method to determine the value of your investment is imperative for its success.

It can be quite challenging to value commercial property. Fortunately, there are a few approaches to try. Having a good understanding of commercial property value is important since it is largely responsible for the sale and purchase of the property.

Let's take a closer look at each method. For a better comparison, we will also list the advantages and disadvantages of each approach.

Income Approach

Known as the Income Capitalization Approach, this is the most common tactic used in commercial real estate transactions that entail determining income funds. Here, the value of the property is calculated by estimating the income of the property by using the capitalization rate (commonly called the cap rate).

It is calculated by dividing the net operating income of the property by its current market value (or sales price). A property with a net operating income of $700,000 and a cap rate of 8% would be valued at $8.75 million ($700,000 / 8% = $8.75 million).

The cap rate is calculated based on market sales of comparable properties in the same neighborhood. If the property has unique features, such as high-quality tenants or an unsightly facade, the cap rate can be adjusted. Ideally, the final cap rate should be within half a percentage point of the local average.

ProsCons
Based on recent sale activity of comparable properties, and can be adjusted for the unique features of the property.Overstates the NOI and value of a property because it does not account for vacancy and collection loss.
It can be applied to any property that generates consistent, predictable income, and thus is the most commonly used method for valuing commercial real estate.A future negative NOI will also result from necessary extensive repairs.

Replacement Cost Approach

Using the commercial real estate value method is a much more complicated process. It begins by taking into consideration the value of the land upon which a building sits (without the building included).

Upon adding this number to the land value, the calculator determines how much would be needed to replicate the existing building exactly. As a final step, the depreciated value is accounted for, and the actual property value is adjusted accordingly.

ProsCons
In practice, the cost approach is not as reliable as the income and comparable methods.It is especially helpful to value the various components of real estate separately.
Due to the lack of comparable vacant land, the appraisal is less accurate when estimating the value. Compared to other methods, it requires much less paperwork.

Market Value Approach

This is perhaps the easiest method of determining the value of a commercial property. Using this method, the property is compared to similar properties in the surrounding area that have been sold or put on the market.

The market research findings are used to establish a range of values, which are then adjusted based on the physical characteristics of the property being valued. The following factors are likely to be considered:

  • Differences between the sale dates
  • Property age and condition
  • Area of the building and surrounding land
  • Address
  • Ratio of land to building
  • Local tax policies

Depending on how a property serves a buyer's needs, a buyer may place a lower or higher value on it, but this is an easy way to set a baseline for negotiations.

ProsCons
A good estimate of value is based on current, relevant data.Unique features of properties can affect the comparability of comparable properties.
The analysis is based on publicly available data on comparable transactions. Commercial property's fair market value may not be accurately reflected by comparable sales.

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Frequently Asked Questions

Let’s shed light on some of the most common questions about the valuation of commercial properties.

What approach is most commonly used for commercial properties?

A property that produces consistent, predictable income is most frequently valued using the income approach, since it can be applied to any property.

How do you compute commercial property value based on rental income?

Using the cap rate as a measure of value, the income approach links the value of a property to its rental income. For example:

Current Value = Net Operating Income (NOI) / Cap Rate

Depending on the unique features of the property, the cap rate can be adjusted based on sales of comparable properties in the area.

How do you determine a commercial property’s estimated value?

Values of commercial properties can be determined by several approaches, including cost and income approaches, sales comparison approaches, and the Capital Asset Pricing Model. When calculating the value of a property, many appraisers and investors use multiple methods.

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