Disclaimer: I am not an attorney and this article is not intended as a substitute for advice from the appropriate legal, zoning, financial, construction and/or tax professionals. This information is provided for educational purposes only and is made without warranties or representations
A critical part of selling commercial real estate, or buying it as an investment, is understanding the value of the land and the buildings on it.
This can be tough! It’s difficult in part simply because, at the end of the day, the fair market value is what you can get someone to pay for it and/or what you’re willing to pay for it, depending on which side of the transaction you’re on.
A parcel with a fair market value of $5,000,000 might not actually have that value if no one bites. Right?
A lot of effort has gone into developing ways to calculate the fair market value of commercial real estate. So much so that there are a variety of different methods you can use to make that calculation. They all have their pros, cons, and uses, and there are often good reasons to pick one over another. Here are the six most common methods used for CRE valuation explained.
First up is the cost approach. It begins with a very simple concept: the value of a piece of real estate is equal to the value of the land plus the cost it would take to build the structures on the land. If a buyer were to buy the land with no improvements on it and reconstruct what exists on it now, whether that’s an apartment complex, a shopping center, an office building, or a more specialized construction, how much would it cost?
There are drawbacks to this method.
First and foremost, a building that has sat for 20 years is not going to be worth what it would be if it was constructed new. Therefore, depreciation is factored into the cost, as is the cost of other improvements made to the building over time.
There are also intangible factors that can increase the value of a property beyond what the cost approach might estimate. For example, if the building is a landmark or otherwise important to local history or culture, it might have a higher value than it would if all you considered were the materials and labor involved in its construction. Similarly, having a noteworthy architect or designer’s name on the building can boost its value.
The cost approach is generally used when there is something unique about the property that is tangible and not comparable to other structures. Something made from a specific material or technique not commonly seen, for example, might benefit from the cost approach.
The cost approach is also broken into two options:
Overall, the cost approach is often used as a “last resort” or as a comparison for a top-end price point. After all, who would buy a building for more than it would cost to build it from scratch?
This is one of the more common options for valuing a piece of real estate in both commercial and non-commercial realms. It’s also known as the market approach because it’s all about harvesting information from the market and making comparisons with the parcel you’re valuing.
The idea is to find other parcels of real estate that share similarities with the parcel you’re trying to price, find their recent sales prices, and apply those prices (with relevant modifiers) to your parcel.
So say, for example, you have a small strip mall with four units for stores. You look around at recent sales in the last few months to see if anything comparable has sold.
Bingo, you find another mall, almost identical in layout and size. You can reasonably assume that the price it sold for is likely to be in the same ballpark as what yours would sell for in the same market.
One of the drawbacks to this approach is that variation in nearly any factor can have a significant impact on the value of a parcel of real estate, and finding something directly comparable is very difficult.
All of this means that the sales comparison approach is most often used in residential real estate since you’re a lot more likely to see a recently-sold house made in the same style or by the same developer, in the same area, as a house you’re currently trying to sell. Still, in some areas and markets, the market approach to CRE valuation is viable and useful.
The third of the three major approaches to valuing a piece of commercial real estate is the income capitalization approach. The theory behind this approach is simple: a commercial property isn’t worth anything to an investor unless it generates income. Therefore, the value of the property is some function of the income it can generate.
A variety of factors are considered for this valuation method. These include:
To calculate the capitalization rate, comparable properties are often used. This is because the capitalization rate formula requires a property value to be assigned, which is circular if you’re trying to use it to find the value of the property. Comparable values are estimated to find a capitalization rate range, and values are calculated from there.
“The formula for the cap rate is to divide the net operating income (NOI) of the property by the capitalization rate (cap rate). The resulting number is the approximate value of the property based on the expected cash flow during the first year of ownership, often called the “1-year forward NOI” (the reason the 1-year forward NOI is used rather than the trailing 1-year NOI is that the return for the buyer of the property is based on future cash flows, not the past cash flows).” – Altus Group.
Despite the circular nature of the calculation, this is often one of the more nuanced and accurate valuation methods for commercial real estate, so it’s very popular.
The three options above are broadly considered the most common, accurate, and popular valuation methods for commercial real estate. There are some other options, though, and they can be relevant in specific circumstances.
The value per door calculation is, for obvious reasons, only used in multi-unit properties like apartment buildings. It can work in two ways; either it can assign a value per unit and multiply that by the total number of units in the property, or it can assign a total value for the property and break it down into the value per unit.
The name comes from each unit generally just having one door.
“Cost per door adapts cost per square foot to property types – primarily apartments and hotels – that don’t quote their prices on a per square foot basis. In this valuation method, an analyst divides the price of a property by the number of hotel rooms or apartment units. Say a 50-room hotel just sold for $5 million.
That equates to $100,000 per room. Like cost per square foot, this method allows for the comparison of properties of different sizes. Exploring the purchase of a 70-room hotel across the street? Given the $100,000 per room standard, $7 million would be in the ballpark.” – Alliance.
This isn’t a very common valuation option because it doesn’t take into account, well, much of anything. It’s kind of an arbitrary decision on the value of a unit, so that value needs to come from somewhere else, meaning one of the other valuation options.
The gross rent multiplier method takes the value of a property and divides it by the income it generates annually to find a ratio. A property valued at, say, 5 million, that generates $700,000 in annual income, would have a rent multiplier of 7.14.
This is used as a comparative number. If other similar properties have similar values but much higher annual income, this property could be purchased and have the income cranked up over time. Conversely, if other properties are valued the same but have a lower income, it might not be sustainable. Valuations out of line with comparable properties can also reveal opportunities – or reasons to avoid a property.
Again, though, this isn’t generally used as a primary valuation method and rather another data point for comparative analytics to help an investor decide if a property is a good investment or not.
Rentable square footage is a combination of the usable square footage of a unit and the square footage of common areas and does not include square footage that doesn’t fall into those categories.
It allows you to see what a cost per square foot would be, to adjust rents per unit and to adjust overall valuation.
“For example, if a building has 10,000 rentable square feet and the average cost to rent per square foot is $12 per square foot annually, a purchase price of $1.7 million will generate 7% gross rental yield. However, if you know you can charge rent of $14 per square foot annually, a valuation of $1.9 million will yield the same gross return.” – First Republic.
As another valuation method that relies on having some idea of the value of the property, this is again not used as one of the primary valuation methods and is a comparative metric.
Of the three primary valuation methods for commercial real estate, you have to decide which method is the one you want to use.
Or do you?
The truth is, part of evaluating a potential investment, or determining a value to list a property for sale, is going through each of these methods and comparing the values they provide. There’s no singular “best” valuation method.
Some methods work better with certain kinds of properties. A property that is utterly unique and does not have any comparables will struggle to use the market approach. A property in an area where properties don’t sell frequently has a similar problem. A new construction that hasn’t had a history of generating income may not be able to make full use of the income capitalization approach without a lot of hypotheticals.
At the end of the day, valuing commercial real estate always comes back to making a deal. As a seller, you have to find a price point you’re willing to accept and a buyer willing to pay that price. As a buyer, you have to know what your budget is and how much you’re willing to pay for a parcel, and if you can’t find any available, readjust your expectations.
Valuing commercial real estate is one tool of many that allows you to get in the right ballpark, set your expectations appropriately, and make the right kind of deal.
Luckily, you don’t have to go it alone. If you’re a buyer looking to snap up a parcel when it hits the market, or a seller looking to get the most out of your real estate portfolio, I’m here to help. As a top-rated broker in California, I’ve got the experience and the history in facilitating sales to prove I can get you the best possible deal and walk away satisfied. All you need is to contact me to get started.
Erik Egelko is a veteran of the commercial real estate business with a specialized focus on Investment Property Sales. In 2021 and 2022, Erik was the #1 ranked Broker in California for one of the largest CRE Firms as well as ranked in the Top 1% of brokers nationwide. He has extensive experience in a variety of asset types including: Retail Shopping Centers, Medical Office Buildings, Industrial Properties, and Multifamily Apartment Complexes. Over the course of his career, Erik has closed over $100,000,000 of commercial property sales throughout Southern California.