October 01 - 2021
For properties you hold or seek to acquire, accurate evaluation is critical for CRE business or investor success. When choosing between commercial real estate valuation methods, what should you keep in mind? Which one works best?
Valuing a multi-unit apartment building, industrial complex, retail shopping center, corporate office building, or any other commercial property can be accomplished by several different methods. If you are wondering how to calculate commercial real estate value, here’s an in-depth look at each method.
For example, a multi-unit apartment could be compared to a building with similar characteristics and/or nearly equal square footage that recently sold in the same neighborhood. Many CRE professionals consider the sales comp method to be the most reliable, as it’s based on current, real-world sales and asking price data.
Historically, this approach, as well as the income capitalization approach, was limited due to data access limitations, but things have improved dramatically. Previously, CRE professionals and brokerages were often restricted to their own databases. The lucky ones might have shared comps with a few other firms in their area.
Today, this commercial real estate valuation method has skyrocketed in value. Why? Because the modern sales comp method leverages digitized crowd knowledge. This ensures comp listings are relevant, accurate, and up to date. Sales comparison and income capitalization commercial real estate valuation methods have benefited from newer technology and availability and easy access to lease and sale comp data.
CompStak, for example, curates comps from over 30,000 CRE professionals to provide a highly accurate profile for any property. The massive database enables dozens of property comparison characteristics as well as valuable market trend analysis. Even if an asset does not have a comparable property in one area, similar assets in other geographies can provide a reasonable valuation.
In the past, a commercial real estate valuation tool like this was unheard of. This is not only due to the power of the data, but also the ease of use and accessibility. The CompStak platform provides access to accurate property information at your fingertips. Now, thanks to advanced data collection and analytics, a new level of valuation speed and accuracy is possible.
Related article: How to Pull Comps for a Property Appraisal in 30 Minutes [Part I]
This commercial real estate valuation method focuses on the amount of income a particular property will theoretically generate in the future. The value can be expressed in terms of rent collected as well as the potential property resale value.
To determine projected income, some investors compare income data from similar properties nearby. Income can be further increased by reducing maintenance costs or by transferring some expenses to the tenant (for example, utility costs).
Factors that figure into the income approach include these calculations:
NOI measures an income-producing property's profitability before adding in any costs from financing or taxes. The capitalization rate (also known as cap rate) is used by CRE professionals to indicate the rate of return that is expected to be generated on an investment property.
Commercial real estate value based on rental income can be useful as it enables you to project the rate of return. However, it also makes it difficult to compare since investors may have different cap rate thresholds. Another drawback to this method is that NOI calculation depends on variables that might lack accurate data.
How much would it cost to rebuild an investment property from the ground up? To derive property value, this commercial real estate valuation method answers this question. For the cost approach, it’s important to consider current land, material, and labor costs in the calculation.
Real estate professionals tend to use the cost approach if comparables are difficult to find. For example, the building might be a highly specialized structure with customized improvements or a new-build in a market that simply lacks a sufficient number of other properties that could be considered similar.
While similar to the income approach, the Gross Rent Multiplier approach is based on gross rent rather than net operating income.
Determining the value of a property using this method is calculated like so:
Property Value = Annual Gross Rents x the Gross Rent Multiplier
Gross Rent Multiplier (GRM) data comes from CRE professionals, investor groups, online resources, and other comparable data sources.
The GRM is a fairly straightforward commercial real estate valuation method. Keep in mind that this method does not account for expenses like repairs, maintenance, or losses sustained from vacant units or unpaid rent, eviction costs, and other expenses.
This commercial real estate valuation method is used to compare similar apartment buildings with different quantities of units. For example, a building with 40 apartments priced at $6 million would be valued at $150,000 “per door”.
Using the per door value, you might compare one building with another property in the area that has fewer units. This way you can calculate a total commercial real estate value estimate.
Remember, this method is only useful if you are using closely equivalent property types. Value per door does not account for square footage, quality, or other costs.
Rentable square footage equals the usable square footage of a building (the space tenants occupy) plus the common areas tenants benefit from, such as lobbies, stairwells, fitness areas, and elevators. This commercial real estate valuation method uses each tenant's rental rate to derive an average cost per rentable square foot, so that you can then evaluate the property as a whole.
But how do you calculate the portion of common space attributed to each tenant? Just use their pro-rata share of the building’s total square footage. For example, if a tenant leases 10,000 sq. ft. in a 100,000 sq. ft. building, 10% of the building’s common space gets attributed to that tenant. In other words, 10% of the common area square footage can be added to the lease square footage number.
The commercial real estate value per square foot can be used to determine a tenant's annual base rent expense. To do this calculation, simply multiply your rentable square feet with your annual base rental rate for your lease.
The Capital Asset Pricing Model (CAPM) is a newer commercial real estate valuation method that tracks risk-adjusted returns compared to the overall market (based on a “beta” variable). The CAPM describes the relationship between the expected return and risk of investing in a real estate asset. It shows that the expected return on an investment property is equal to the risk-free return plus a risk premium, which is based on the beta of the property.
The beta is a measure of an asset’s risk reflected by measuring the fluctuation of its price changes compared to the overall market. For instance, if a prosperity’s beta is equal to 1.5, the investment has 1.5x of the volatility of the market average. However, if the beta is 1, the expected return on the asset is equal to the average market return.
This model has not seen widespread use in the real estate sector, and some consider it too experimental. Still, as the science of calculating commercial real estate value evolves, new techniques should be considered for future usefulness.
When it comes to evaluating commercial property value, it pays to have knowledge about the different methodologies. No two deals are exactly alike. In some instances, one method may work better than others. Or you might work with a combination of techniques.
It’s never been more important for CRE professionals to stay informed about new appraisal methods. For example, the digital age has revolutionized the sales comparison approach. Now, platforms like CompStak place an entirely new level of data-driven decision-making in the hands of any CRE professional. In the end, this translates into more closed deals with improved business outcomes.