Investing in commercial real estate is different from residential property as calculating a commercial property’s value is a bit more difficult to assertain. Nonetheless, it’s essential to any investor’s playbook. A commercial real estate valuation is necessary when accredited investors want a fair market value for a property.
When a business owner seeks to purchase an existing structure, it’s wise to conduct market research to determine if the selling price matches the property’s current value. They can do so by taking a market approach to determine if a similar property type is in the same market at a similar price.
Several ways to calculate commercial real estate differ from evaluating residential real estate. These methods accurately determine property value and give a fair comparison to other sold and for-sale properties in the area.
Square footage, gross rental income, recent sales, sales comparisons, operating expenses, projected income land value and the value of similar properties are some factors that affect a particular property’s current market value.
Here are some common valuation methods.
Why Does Commercial Property Value Matter?
If a purchaser is looking for a commercial real estate property, they want to know that the land or building’s value they’re considering is worth their money. The last thing any business or nonprofit owner needs is to buy a property based on incorrect information.
Sellers must know what the estimated sales price will be so they can strategize accordingly.
How to Value Commercial Real Estate
A buyer or seller can determine commercial real estate value using many methods. Here are some common strategies investors use to compare properties and determine an accurate estimate.
Sales/Income Approach
Many real estate investments are valued based on the income they bring to the owner. This is where this income and sales comparison approach comes into play.
It’s an income capitalization approach, which references the cash flow purchasers are inheriting. For this calculation method, they’ll want to look for the income capitalization rate — the anticipated cash-on-cash return of the asset.
This approach calculates the rate by dividing the annual income by the purchase price. For example, $200,000 income per year divided by a $1 million purchase equals a 20% cap rate.
Gross Rent Multiplier
The gross rent multiplier (GRM) is a valuation method that looks at the ratio of a commercial real estate property’s total price divided by its gross income.
It’s a great way to compare similar rental properties in neighboring areas. Using the calculation, buyers can compare how long it will take to pay each property off.
For example, if someone bought a building for $200,000 and receives $20,000 per gross rent, then the GRM is 10.
They can also use the inverse of this method to calculate an investor’s value of each commercial property. If a buyer wants to pay off the property in five years, they’ll look for one with a gross rent multiplier of five. If the annual rent income is $10,000, they’d times it by five to see a total investment value of $50,000.
The only downside of this valuation method is it can be subjective depending on the net operating income and how different commercial real estate investors apply their GRMs.
Cost Approach to Valuation
The cost approach method of valuation compares properties based on the cost to rebuild the structure from scratch, from achieving the land value to gathering the construction materials.
We use this approach when it’s hard to find comparable properties, such as when the building has specialized needs.
To calculate the construction costs, add the prices of rebuilding the foundation, walls, and roof, as well as plumbing, ventilation and other major features.
The cost approach is an excellent way to determine whether a property is priced at a fair market value.
Value Per Door
Value per door is a quick and dirty way to calculate the value of a commercial property. It works well for apartment buildings or multifamily homes. We determine the building value by the cost of each door in the price.
For example, if a buyer has 40 apartments priced at $4 million, the value per door would be $100,000 per door, regardless of different use sizes.
Comparing the value per door determines a realistic valuation for each apartment building they consider that isn’t based on the rentable square foot of the unit.
Evaluating Commercial Property Using the 2% Rule
A common way to determine commercial real estate property value is using what real estate agents call the 2% rule. If the average least cost for the property is at least 2% of the purchase price, it will likely lead to positive income for a new owner.
The calculation for this is the average lease cost of the property divided by the purchase price equals X. If X is less than 0.02 (2%), then it does not meet the standard.
Comparison of Sales
Buyers can compare similar assets by their location, square footage, size, acreage, age, construction type, maintenance costs and more.
Compare values by taking each property’s price per square foot and multiplying it by different aspects.
For example, if the price is $100 per square foot and the property is 3,500 square feet, they would multiply them to get a commercial property value of $350,000. To complete the sales comparison, buyers can then adjust the values of different aspects by multiplying each by $100.
The sales comparison approach is most often used for vacant properties, so their income is out of the equation. A purchaser can instead review CRS data or tax records to find comparable properties in the area.
Factors Affecting the Value of Commercial Property
Many factors affect the value of a commercial real estate property that are hard to predict. They include the economic outlook for the local area, nation and world.
Unemployment rates greatly affect what buyers can afford to spend on a property, while inflation impacts what the seller can reasonably price it at.
These variables and others can happen when finalizing commercial property purchase, derailing the deal.
Cost Estimation
Cost estimation considers all the factors involved in making a commercial property what it currently is. It can include internal and external market factors, the cost of building materials, and upgrades made to the property by the current owner.
Using the calculated property value to create an estimated cost lets sellers fairly price their property for themselves and potential buyers.
What Affects Commercial Property Value?
Some factors are easier to predict and greatly impact a commercial property’s value.
Supply and Demand
The supply and demand of similar commercial real estate properties in the area impact the amount charged for the property. Buyers look at properties with their desired square footage, net operating income, and other details. A commercial property becomes more valuable if it is one of the only options available, as buyers are willing to pay more.
Capitalization Rates
The comparison of capitalization rates between properties also affects their value. The sales/income valuation approach outlined above produces the capitalization or “cap” rate for that property. The capitalization rate affects whether the purchaser wants to move forward with a property.
Transferability
Buyers need to know that if they purchase a commercial real estate property, they can sell it if the need arrives. If any other potential buyer does not value the property, the current buyer will be stuck with it.
Replacement Costs
Like a cost approach, the replacement cost focuses on what it would take to recoup a particular investment if something happened to the property.
A desirable building doesn’t need much repair or renovation, so the estimated cost is considered when calculating. Often, this method is used alongside sales comps to determine if the investment is worth the purchase or if building their commercial property is preferable.
They’ll need to know the cost of building a new establishment to do this calculation.
Once a buyer knows this information, they can calculate the replacement cost to a delta. The delta is either positive or negative, showing whether or not they’d be making a positive investment in the available building.
The equation is new construction cost minus the acquisition cost and renovation cost combined equals the delta. A positive one means the profit on the established building may be worth it.
Utilities
A building’s size, energy efficiency, and location impact the costs of a commercial property’s utilities. Water, energy, and electricity can all cost significant money. No matter the cost of the property itself, exorbitant utility costs will turn some buyers away.
Conditions of the Market
Using these tools is an excellent way to determine the value of commercial properties using other methods, but there’s a chance that the market will throw those calculations out the window.
In the end, commercial property is only worth what a buyer will spend on it, which is why some properties sell for more or less than expected.
The economy and timing make a huge difference in the value of an investment property, with similar properties in the same market costing significantly more or less per square foot than the other.
If buyers want to purchase a property soon, they can look at recent sales, including the sales price and operating expenses.
Commercial Property FAQ
Commercial property values are calculated by quality, comparable properties, and rental income. Outside factors, such as the economy and commercial real estate market, also impact value.
Determine the commercial real estate value of a specific property using a calculation method that fits the type of building and compare that value to comparable properties in the area.
Commercial property is only as valuable as buyers see it. Various factors determine this. The market also has a huge role in determining value.
A buyer can determine if a commercial property is a good investment by using an appropriate valuation calculation and comparing it to other local properties.
Final Thoughts About Commerical Property Valuation
Calculating the value of a commercial property differs from residential real estate. ensures buyers are getting the best deal possible. It’s worth the time and effort to get accurate commercial appraisals when searching for a property.
By gathering knowledge and using one of the above valuation techniques, commercial real estate valuation can be simple and accurate.
