Commercial real estate valuation is a complex task, especially when compared to residential properties. Not only is it challenging to determine the value, but there are also various methods professionals employ to assess commercial property value. Accurately determining the value of a property can help identify overlooked investment opportunities and avoid overpaying for a property.
Why CRE Valuation is Important
Determining the fair market value of commercial property is crucial for both investors and lenders. Commercial real estate investors rely on the valuation process to determine the purchase price, evaluate potential value-add opportunities, and assess if a property aligns with their real estate portfolio strategy.
Lenders also utilize commercial property valuation during the underwriting process. Most commercial real estate loans have a maximum loan-to-value ratio (LTV) of 70%. The lender's property valuation determines the borrower's down payment amount, the length of the mortgage, and may also influence other loan terms and conditions.
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Factors Affecting the Value of Commercial Property
Determining the value of commercial real estate involves considering various factors that go beyond just the cost of the property. Four essential factors that impact commercial property valuation are:
- Desire
- Utility
- Scarcity
- Effective purchasing power
For a property to have value, these factors must complement each other. For example, even if a particular type of commercial property is scarce, it will have minimal value if it does not fulfill the buyer's needs, such as generating rental income through a lease.
6 Ways to Determine the Value of Commercial Real Estate
Valuing commercial real estate is more complex than valuing residential properties. Here are six approaches to help determine the value of commercial property:
1. Sales comparison approach
Also known as "pulling comps" or the "market approach," this method relies on recent sales of similar properties in the same market or submarket.
2. Cost approach
The cost approach is often used for special use properties or when comparable sales are challenging to find. It calculates the value based on the cost of building the property from scratch, including the land's value, materials, and construction costs.
3. Income capitalization approach
This method uses the net operating income (NOI) generated by a property to determine its value in relation to similar properties in the market. It calculates the value based on the cap rate and the property's NOI.
4. Cost per rentable square foot
This method subtracts the rentable square footage from the total square footage and compares the cost per rentable square foot to the average lease cost. It helps project the potential gross rental income.
5. Cost per door
The cost per door method is commonly used to compare the value of different apartment buildings. It calculates the value by dividing the price of the building by the number of units.
6. Value per gross rent multiplier
The gross rent multiplier (GRM) is used to compare different properties quickly. It is calculated by dividing the property purchase price by the gross annual rent. A lower GRM indicates a higher potential for the property.
CRE Valuation Terms to Know
Before determining the value of a commercial property, it's essential to understand these common appraisal and valuation terms:
- Price per square foot: Calculated by dividing the property asking price by the square footage, it doesn't consider factors such as rental income or property condition.
- Net operating income (NOI): The property's annual income minus operating expenses, excluding debt service.
- Cap rate: Calculated by dividing the annual NOI by the property value. Cap rates help forecast the potential rate of return on an asset.
- Debt service: The repayment of principal and interest on the mortgage used to purchase a commercial property.
- Gross rent: The total income generated by a commercial property, including rent payments and other sources.
- Value: The estimated worth or selling price of a property based on its income stream and one of the valuation methods discussed.
Determining the value of commercial property is both an art and a science. Experienced investors combine their business acumen with accurate data to find and assess the best commercial real estate deals across different markets.
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