The purchase, sale, borrowing or even leasing options for a piece of commercial property often hinge upon the appraised value of the building. Assessing that value, however, is no simple matter. Whether it’s an apartment building, an industrial complex, a retail shopping center, or an owner-occupied business structure, commercial appraisals are generally more subjective than residential reviews.
Why? Commercial values are often dependent upon uncontrollable elements like the current market price for which spaces rent, fewer available comparables and overall maintenance costs (which can vary dramatically from industry to industry). And then, of course, there’s the tricky question of how much a buyer is willing to pay.
With so many variables to consider, how does an investor or small business owner price a potential property? There are three valuation methods often used to determine intrinsic value.
This valuation method considers the cost to rebuild the structure from scratch, taking into account the current cost of associated land, construction materials, and other costs that would be associated with the replacement of the existing structure.
Cost approach is generally applied when appropriate comparables are difficult to locate, such as when the property contains relatively unique or specialized improvements, or when upgraded structures have added substantial value to the underlying land.
Sales Comparison Approach
Also known as the “market approach,” this method relies heavily upon recent sales data for comparable properties. By seeking recently sold buildings with similar properties from the same market area, a buyer hopes to ascertain a fair market value for the property in question.
For example, a 12-unit apartment building might be compared to another that sold in the same neighborhood just a few months earlier. While this valuation method is typically used to value residential real estate, it does have one significant drawback. Depending on general and localized market conditions, it can be difficult to find recent comps that have similar properties.
Income Capitalization Approach
This valuation method is based primarily on the amount of income an investor can expect to derive from a particular property. That projected income could be derived in part from a comparison of other similar local properties, as well as from an expected decrease in maintenance costs.
Say a building is purchased for $1 million, and the expected yield is 5 percent, based on local market research. That $50,000 per year in expected income could be enhanced by tightening inefficiencies, or by passing along other associated costs to the tenant, like electric or water usage. All expected future income is discounted to reflect present value.
In addition to the three most commonly used valuation methods discussed above, there are several additional methods that can offer valuable insight for a potential investor.
Value Per Door
Occasionally used to value apartment buildings, this valuation method breaks down the building’s worth by the number of units. A building with 20 apartments priced at $4 million, for example, would be valued at $200,000 ‘per door’ irrespective of each unit’s size.
Value Per Gross Rent Multiplier
The Gross Rent Multiplier (GRM) is a back-of-the-envelope calculation used to measure and compare a property’s potential valuation by taking the price of the property and dividing it by its gross income. This method is generally used to identify properties with a low price relative to their market-based potential income.
In the end, every buyer values property differently. The valuation of commercial property does have a subjective and unscientific component. The best commercial real estate investors have honed their gut instincts around finding the most attractive deals, and the most effective valuation methods for each particular type of transaction. At the end of the day, no matter how much analysis has been conducted, the value of commercial real estate is always in the eye of the beholder.
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