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The Top Three Commercial Real Estate Valuation Approaches: EXPLAINED

By: Space Selectors   October 12, 2019

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If you are looking to answer the most important commercial real estate question, you are in the right place. The question: What is that property worth in reality? You know the list price, and you know the comps (comparable sales). Now you need to discover exactly what that property is worth based on reliable data. Then, discover what it is worth to your specific company. As such, you must go beyond the simple real estate appraisal and general commercial real estate valuation. To elaborate, uncover how well your company will perform at that specific location, regardless of the actual real estate value.

 

Appraisals focus on what the general public will pay for a given property. But, you are not the general public. You have a specific type of business. Therefore, you need to find a location where your company will thrive. Here, I’ll show you how to do exactly that, after walking you through the best commercial real estate valuation approaches. So, continue reading to learn the top three approaches to commercial real estate valuation. Then, uncover how to determine your unique business-performance potential at a specific location.

 

Preliminary commercial real estate valuation

 

Initially, your commercial real estate agent performs comps to fetch a quick valuation of a specific location. Comps are comparable sales. So, “sold” listings reflect more accurately, the value of the property you are investigating. Sellers may ask any price they wish, but it is important to know how much they can get for their properties. Therefore, if it sold, you will know how much someone was willing to pay. Then, when you compare three or more “sold” listings, you get a good idea about what the public is willing to pay – the market value.

 

Comps are a market data approach comparing recently sold real estate within the same market conditions. Then, your agent adjusts the value based on specific qualities and features of the property. For example, your agent will consider the condition of the building and specific features such as quality of construction, landscaping, square footage, rooms, and lot size, to name a few. Of course, it is generally difficult to find recent comparable market data when performing your commercial real estate valuation.

 

As you will see moving forward, there are more comprehensive commercial real estate valuation approaches to determine the actual value of a property. But, comps are important for lenders and investors. To explain, lenders and investors rely more on actual property value within the real estate market. They use that to determine how much funding they are willing to lend or invest. This explains why comps are so important for residential real estate – residential valuation is based solely on real estate market value. On the other hand, your primary concern is the property value to your specific business. Therefore, let us look at the top three commercial real estate valuation approaches, next.

 

1. Cost approach to commercial real estate valuation

 

Also based on real estate market value, the cost approach reveals a deeper real estate valuation. Primarily used when commercial real estate activity is low, this method shows the value of the land and the building, which are determined separately, then added together. Like the market approach: comps, the cost approach is primarily used by lenders and investors. It provides a more reliable value, since commercial real estate comps are generally much more difficult to pinpoint using comparable sales. When comps are used with residential real estate, homes within specific neighborhoods are similar in overall quality and features, making their values easier to compare and determine.

 

The cost approach assumes that buyers would not spend more for an existing building than they would spend on the land and the construction of an equivalent building. That would only be the case if there is no available land in that specific area and there was a reason for the extended value, like a famous landmark on the premises or something of value on the property that is permanent and irreplaceable.

 

Land valuation

 

The cost approach begins with the land itself. Land is much easier to value based on comps, since there are no other aspects to compare, except the condition of the land itself. These comps are strictly focused on location, size and of course, condition. Location, which is the most important aspect of any real estate property, encompasses everything else. First, consider the quality of the land itself, and everything around it. Is there a view? Are there any water features on or near the property? What are the crime statistics of the area? Are there any attractions nearby and what are they? Finally, what are the traffic statistics – both foot traffic and car traffic? The answers to these questions, along with other factors and the actual comparable sales, can all be used to accurately determine the value of the land itself, with no structure built upon it. Now you have the first number, which will be added to the price of the building or structure on the land.

 

Building or structure valuation

 

The cost of construction is determined using one of four methods. Each method calculates the cost to build the structure(s) on the property at today’s prices, using various levels of detail, from rough estimation, to time-intensive highly detailed calculation. Then, depreciation of value is applied to the formula. This accounts for physical deterioration, out-of-date design styles, and lack of modern features. There is a cost to upgrade the building to modern standards, which is an important factor.

 

Four building valuation methods:

 

1. Comparative unit method uses a lump-sum valuation typically based on the cost per square foot. Square footage cost is determined using construction-cost comparisons to structures of similar quality. As such, builders typically provide construction quotes based on cost per square foot, using this method. Therefore, once you know the cost per square foot, simply multiply that by the number of square feet in the building.

 

2. Segregated cost method breaks down the structure into various building components, such as the foundation, the walls, the HVAC systems, electrical wiring, plumbing, and the roof. Then, each component is given a cost. Lastly, the costs are added together.

 

3. Unit-in-place method breaks down the components even further. To explain, the HVAC systems are broken into individual parts, like the duct work, the compressors, and the ventilation fans. This provides a more accurate cost per component for the segregated cost method.

 

4. Quantity survey method is the most accurate building valuation method. But, the quantity survey method is the most involved and it takes the most time to complete. It breaks down the construction to exact quantities of everything from bricks, nails, boards of each dimension, and all other building materials. Then, labor costs and all other costs are determined in the same fashion.

 

Building valuation can be simple – close but not exact, or exact and very time consuming – or something in between. Then, the value is added to the land valuation figure to determine the entire value using the cost approach.

 

2. Income approach to commercial real estate valuation

 

Using two primary methods, the income approach is the most frequently used commercial real estate valuation technique. The first method used is called Direct Capitalization, which is based on one year of income. By dividing the Net Operating Income of one year by a Market Capitalization Rate, the Direct Capitalization method determines an estimated future income. It assumes all income and expenses used are current, perpetual, reliable and consistent – nothing out of the ordinary occurred that year. The next method is Discount Cash Flow, which is a projection of cash flow based on a multiple-year period. It is used to forecast the future income and the reversion value, which is what the investor expects to receive as a lump sum after an investment.

 

The income approach is typically used for apartment buildings, office buildings, retail stores, hotels and other steady-stream income businesses. Also, it is arguably used for the commercial real estate valuation of industrial buildings as well since this approach can generally be used with any property that produces consistent, predictable income. Of course, that eliminates any buildings with space for sale, like condominiums or individual office spaces that are sold within the building.

 

Looking at the equation used by the income approach, this method appears to be incredibly simple: Net Operating Income ÷ Market Capitalization Rate = Property Value. Of course, the effort and possible difficulty lies within the two factors of the equation: Net Operating Income and Market Capitalization Rate.

 

Net Operating Income

 

When calculating the Net Operating Income, only use consistent income figures – never use sporadic, one-time or temporary income in your calculations For example, consistent income figures include all possible reliable repeat revenue like rental income, proceeds from vending machines, parking fees, billboards and signage fees, and other relevant on-site service charges. Then, always make sure you calculate Net Operating Income before accounting for capital costs, amortization, depreciation, and taxes. Finally, Not Operating Income is calculated using a Pro Forma, which refers to the process you perform to calculate financial results using Direct Capitalization or Discount Cash Flow, described above.

 

Market Capitalization Rate

 

For the second factor of the income-approach equation, the Market Capitalization Rate is determined by evaluating the real-estate activity in the area. As an example of possible values, 3% to 4% is typically used if the commercial real estate is in a highly active area. But if the area has low real-estate market activity, 6% to 7% is typically used. Keep in mind that small adjustments to the Market Capitalization Rate will cause large changes in the results – it is highly sensitive. Therefore, make sure the value you use is supported by good data from recent sales in the area.

 

Importance of quality assumptions

 

Accurate commercial real estate valuation requires quality assumptions based on reliable data. And the more data you have, the better your assumptions will be. Therefore, make sure you get as much property financial history as possible. Also, utilize as many available resources as you can, like CBRE (United States Commercial Real Estate Services), REIS (Commercial Real Estate Data and Analytics), CoStar (Leading commercial real estate valuation research company), and others. Finally, support your data with comparable income and expenses from similar properties in the area.

 

3. Gross rent multiplier approach

 

This is an alternative approach to the income approach for commercial real estate valuation that is faster and easier. The primary difference is the use of gross income versus net income, which is used in the income approach. Thus, it is simplified. To explain, it takes the property price and divides it by the gross income. You end up with a quick and dirty estimated valuation that is surprisingly accurate, without calculating all the individual income and expense line items. The equation is equally simple compared to that of the income approach: Property Value = Annual Gross Rent X Gross Rent Multiplier. The difference being, there is no labor involved in determining the factors – just simple math.

 

To determine the Gross Rent Multiplier, simply divide the selling price of the property by the gross income from that property. Then, multiply the result with the annual gross rent, and you have a quick and dirty commercial real estate valuation. Finally, compare the Gross Rent Multiplier against comparable properties. You can find this information from local commercial real estate agents and appraisers.

 

Your unique business-performance potential

 

If you plan to install your own business into the commercial property you purchase, it is time to perform a little market research by answering some questions. First, where are your customers? Either know where they live or where they go according to their demographics. Then, will they arrive by car, foot traffic, or light rail? Make sure the location accommodates your customers well.

 

The next question is: who and where is your competition? Start by investigating similar companies within the local area. Then, determine which ones are successful long term, and which ones are new or failing. Finally, evaluate their business model and brand loyalty. It is good to know who you will be up against and how they might help you. You will be surprised to find that they can provide you with new clients. Just differentiate your company and beat them at their own game. Customers already travel to your region for similar products or services. So, invest in your potential customers – advertise well and give them something free. They may become long term patrons.

 

Finally, where will you find your best employees? Finding reliable and skilled employees is difficult. Therefore, confirm there are potential candidates near you. Good local employees will be your goal. So, do your homework and think about placing job ads ahead of time, just to confirm you will find good candidates to fill your new job openings after you set up shop.

 

Space selectors in Denver

For more information on locating, negotiating, and leasing commercial real estate in Denver, contact Space Selectors today. They will provide you with resources for all your Denver commercial real estate needs.

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