How Commercial Real Estate Is Valued
The Three Different Approaches for Valuing Commercial Real Estate
Like most investments, valuing a commercial real estate asset is both an art and a science. But if you believe valuing commercial real estate to be similar to valuing your home, you’d be surprised to find out that it is, in fact, quite different. To be clear, this is purely for investment purposes on commercial buildings since vacant land and owner-occupied buildings are likely valued using other metrics and/or for other purposes. However, for investment purposes, there are three different techniques used to value commercial real estate assets as an investment. These are (1) the cost approach, (2) the sales approach, and (3) the income approach.
Using the Cost Approach to Value Commercial Real Estate
To use the Cost Approach, one needs to find out the current cost of construction to build the exact same building from the ground up. This valuation must take into consideration the value of the raw land plus the current construction costs to build the structure as well as the cost to finish the building’s interior. While not widely used, this technique is always good to keep in mind, especially when considering a new development or in areas where data for the following two other techniques is not as readily available.
Valuing Commercial Real Estate Using the Sales Approach
The Sales Approach uses sales data from comparable buildings. These buildings are in comparable locations and sold as recently as possible. This approach is widely used to compare residential real estate but becomes considerably more challenging on the commercial side. That is because one must take into account a variety of factors that make commercial real estate so different in order to find recent sales of truly comparable buildings. Some of those factors include the property type (office, industrial, retail, apartment, hotel, etc.), property size, geographical location, and so on. Typically, several building sales are looked at on a price per square foot basis (which is simply the sale price divided by the total square footage of the building) in order to come up with an idea of how a particular asset compares against the others in a competitive group. This approach can be valuable to spot current and historical pricing trends in any particular market.
How to Value Commercial Real Estate Using The Income Approach
The Income Approach is generally considered the most important technique when valuing commercial real estate assets. This approach determines a property’s value based on how much income the property is expected to generate. In order to come up with this valuation, it is important to understand the actual current revenues and current expenses at the property as well as any factors that could change these numbers in the near term. These factors include but are not limited to current vacant space, expiring leases, planned increases/decreases in lease rates, variable vs. fixed expenses, etc. Current revenue minus current expenses is called the Net Operating Income (NOI). To determine the value, in addition to determining the NOI, one needs to consider the Capitalization Rate (Cap Rate). The Cap Rate is a ratio that reflects the anticipated annual return an investor expects to achieve on an investment (that does not include any debt/leverage) before taking into account capital costs and real estate taxes.
For example, Cap Rate = Net Operating Income / Value.
Therefore, Value = Net Operating Income / Cap Rate.
Using the Income Approach, once the NOI is known, one must assign a Cap Rate for the particular investment to come up with a value. While the Income Approach is most often used, we can see that each individual investor’s return parameters (as reflected here in the Cap Rate) can differ, thus creating widely different values on the same commercial real estate asset even when using the same Net Operating Income. Several factors that can affect the Cap Rate include interest rates (as a comparison against other asset classes), the length of tenant leases, the creditworthiness of the tenants (which reflects their likelihood of defaulting on their lease obligations), as well as the market demand for each asset type.
—
Often, investors will look to all three of these valuation techniques to come up with their own valuation. These three techniques are primarily based upon numbers and are the science to commercial real estate investing. The art lies in the ability to know and spot trends relating to macro and microeconomic factors, property types, and market/submarket factors. For example, if an investor believes strongly that the prevailing leasing trends will push the current rents in a building considerably higher, then that investor might come up with a higher valuation for the building as compared to another investor who doesn’t believe in the prevailing leasing conditions. Even though both investors are using the same NOI for their valuations, we can see how different Cap Rates, and why they might be different, can dramatically change values. Other considerations for investments also include future interest rate levels, future Cap Rates upon sale (as future sale prices affect ones achieved returns), capital expenditures required for deferred, current and ongoing property maintenance, among other factors.
Once you own a property, the work is not done, and your valuation isn’t static. There will always be factors that change the value of a building. It is also paramount to have plans in place in advance so that an investor can quickly pivot strategies to take advantage of situations that will increase the value of your investment. And more importantly, explore ways to minimize situations that will negatively impact your investment. When comparing different commercial real estate investments, the ability to use both the art and science of valuation can be the driving factor in finding and achieving the best risk-adjusted returns.
If you would like one of our experienced brokers to help with an opinion of value, or assist in finding your next real estate investment, please let us know. We’d be happy to help!
Rokos Advisors is an award-winning Minneapolis – St. Paul-based commercial real estate/tenant representation firm specializing in helping businesses find the perfect office or industrial space for their company.
*Article authored by Rokos Vice President, Michael Klisanich