When you invest in commercial real estate, it’s vital to know the value of your assets. This statement seems logical since the value is essential information for buying, selling, financing, and paying taxes. However, it isn’t always simple to determine a fair price for a property unless you want or need to sell it (since, ultimately, how much a buyer will pay is one bottom line approach to valuation). Also, keep in mind that land value differs from a developed parcel's value.
Commercial property values are influenced by rental prices, occupancy percentages, maintenance costs, and other external factors. Also, determining value can be difficult when few comparable properties are available.
What methods are typically accepted for valuing commercial property?
Many investors use one of the following or a combination of these methods:
Market approach (traditional comparison model): This method looks for recently sold buildings like the property in question. The points of comparison include size, function, age, condition, location, sector, and class. This approach is generally reliable if adequate comparison properties are available. This sales comparison approach is commonly used in residential real estate, which typically offers more data to work with.
Cost approach: Cost valuation estimates how much it would cost to rebuild the structure from scratch, including land, materials, labor, permits, and other expenses. Investors will use this method when comparable properties aren’t available for assessment or when a property is unique.
Gross rent multiplier: This valuation tool estimates the property’s value by dividing the purchase price by the annual rent income.
Income capitalization approach. Determining a property’s value through income capitalization analyzes how much income the owner can expect to derive from the asset. This method is also referred to as direct capitalization and takes the net operating income and divides it by a predetermined capitalization rate. Investors can find that rate by examining market sales of comparable properties, so this method requires good data on similar deals. This method also assumes that the property is stable, with a standard rental rate and occupancy.
The simple formula for income capitalization is Market Value = Net Operating Income/Capitalization Rate. For example, suppose the investor is evaluating a multifamily apartment building with a capitalization rate of 9% and a net operating income of $500,000. The value using this method is $5,555,555.
How do I determine Net Operating Income?
The income capitalization approach is well regarded among many investors, as long as the data for comparable sales is available and they can determine the Net Operating Income (NOI). To find the NOI, take the total revenue (income) and subtract operating expenses. Income typically consists of rent but can also include extra charges for amenities like parking, laundry, or concierge service.
Operating expenses include maintenance, utilities, repairs, management expenses, property taxes, and insurance but not the cost of paying a mortgage, depreciation, or income taxes. Remember, this method works best when the property operates efficiently and has expected occupancy. If those conditions are not optimal, the investor may want to adjust the value estimate accordingly. For example, if the buyer has plans to improve the operating expenses or decrease vacancy, they may consider that in the calculation.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Examples are hypothetical and for illustrative purposes only. Withdrawal strategies should take into account the investment objectives, financial situation and particular needs of the individual.
