Various factors determine the value of a commercial property, and it's difficult to pinpoint which has the most significant influence. Many people who invest in commercial real estate may not fully understand how to evaluate their potential investments or what factors to consider when doing so.
Commercial real estate value depends on many variables, some of which rely on the market and the asset’s affordability.
How to Evaluate Commercial Real Estate
In the world of commercial real estate investing, there are many methods used to evaluate properties and determine their worth. These approaches determine how much a commercial real estate property is worth at its land value, which takes into account any leases, mortgages, upgrades, or other factors influencing what the property is worth.
Keep in mind that land value differs from property value; property or site value refers to the worth of your property before considering upgrades you’ve done, leases, or other unique factors. You can assess property value simply by comparing your lot to those surrounding it.
Here are a few approaches to help calculate the land value of your commercial real estate property.
Sales Comparison Approach
The sales comparison approach for valuing commercial real estate is based on recent sales of similar properties in comparable markets. For instance, a 62-unit apartment complex in a suburban town may be compared to one of similar capacity and age in a neighboring city. To get the land value rather than the property value, you’ll need to look at properties with similar upgrades, leasing models, or features to your own.
Therefore, the land value of a commercial real estate property may be challenging to determine if there are no similar properties in the surrounding areas.
Cost Approach
The cost approach is used if you cannot find similar properties to compare yours to or if your property has unique features. This method determines the property’s land value based on the price of the land itself, plus the costs of construction of the commercial building, minus its expected depreciation.
Income Approach
A property's future income can be calculated using the income approach. The projected income for your property may depend on the past incomes of similar properties and their maintenance costs.
Using the income approach, you can calculate the value by using the anticipated net operating income (NOI) and the capitalization rate. The NOI encompasses all revenue generated by the property minus operating expenses. The capitalization rate is calculated by dividing the NOI by the current market value of the property. The capitalization rate is used to determine a rate of return stated as a percentage.
Take a property with a value of $720,000 with a gross profit of $120,000 and $70,000 in expenses. The NOI is 120,000-70,000, or $50,000. The capitalization rate is 50,000/720,000=6.9%. The annual expected return is 6.9% of the initial purchase, assuming the property was purchased for cash.
Gross Rent Multiplier (GRM)
The Gross Rent Multiplier (GRM) valuation method calculates and analyzes a property's potential value by dividing the purchase price by the annual rental income. This formula is important because it allows you to compare properties as long as you have two of the three components: the property value, average annual rent (or monthly multiplied by 12), or the GRM.
GRM is a simple formula used when comparing properties. When doing it based on annual rent income, the GRM should fall between 4 and 7. If above 7, then it will be hard to pay off the initial investment of the property value. If below 4, the property is incredibly profitable but is likely a risky market because of the high margins.
For example, if the commercial property value is $800,000, and the expected annual income is $125,000, the GRM is 800,000/125,000=6.4. If you know either the property value or the average annual income, then you can calculate the other using the GRM as an estimate.
The resulting 6.4 GRM is within the range of a healthy margin, so the property could be viewed as a good investment. The largest drawback of GRM is that it does not factor in some crucial aspects such as expenses. While GRM is good for a simple comparison of property values, it’s necessary to consider other variables before investing.
Choose the Right Approach to Determine Commercial Real Estate Value
These commercial real estate value calculations are all viable options for real estate investors looking to determine the land value of a commercial real estate property. The best method depends on the circumstances of the real estate market and the general commercial real estate trends in the geographical area where the property is located.
A savvy investor will use these approaches to assess the total value of a site and its buildings before determining if it's worth adding to their portfolio.
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. It should also not be construed as advice meeting the particular investment needs of any investor. 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. Past performance is not a guarantee of future results. All real estate investments have the potential to lose value during the life of the investment. Income and appreciation are not guaranteed. Examples shown are hypothetical and for illustrative purposes only.
