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No question is more important when buying commercial real estate than: “How much does it cost?” But the question is even more meaningful if you also have a good idea of how much the property is worth. Putting a value on commercial real estate is part science and part art, but thankfully there are several valuation methods at your disposal. Whether you plan to operate your business out of the property, use it to generate rental income, or fix and flip it, knowing the right amount to pay can make all the difference between a profitable and losing transaction.
Glossary of Commercial Real Estate Valuation Terms
Here is a short glossary of terms commonly used when determining a property’s value.
|Cap rate||The capitalization rate equals a property's net annual rental income divided by the current value of the property. It ignores the impact of financing and potential upside due to below-market rents. The cap rate represents the expected or required rate of return on the property.|
|Cost per unit||Cost per unit is the price of a property divided by its number of rental units. It does not consider the type or size of units, income or physical condition.|
|Debt service||The amount each month or year for payment of interest and repayment of principal is also known as debt service.|
|Gross potential rent||The amount of rent collectible from a multi-tenant property if all rents are paid in full and all units are fully rented is gross potential rent, also called gross scheduled income.|
|Gross rent||This is the average rent paid by a lessee. The average is taken over the months in which the lessee is obligated to pay rent and is also known as effective gross rent.|
|Gross rent multiplier (GRM)||The sales price of a property divided by its annual gross potential rent is the gross rent multiplier. It differs from cap rate because it ignores expenses. Also, it excludes physical condition and potential upside due to below-market rents.|
|Net operating income (NOI)||Net operating income is equal to the rental income from a property minus all the expenses associated with owning the property.|
|Present value||In this context, this is the sum of future rent payments, in which each payment is discounted by a time-related factor.|
|Price per square foot||This is the price of property divided by the square footage, and it does not consider the number and type of units, income or physical condition.|
|Return on investment (ROI)||The return on investment equals the cash flow after debt service divided by the cost of the investment.|
|TUMMI||Property-related expenses: taxes, utilities, management, maintenance and insurance are referred to as TUMMI.|
|Vacancy and collection loss||The rental income lost due to unrented units and uncollected rents is the vacancy and collection loss.|
|Value||The most probable price a property should bring in an open market with knowledgeable buyers and sellers is its value. For investment property, it should equal the present value of the projected future rent stream.|
Commercial Real Estate Valuation Approaches
These are the valuation approaches commonly used for commercial real estate:
The cost approach values the property as equal to the land price plus the cost of constructing the building from scratch. For example, if a tract of land costs $40,000 and the price of constructing a six-unit apartment house is $600,000, the cost approach yields a value of $640,000.
The cost approach assumes that the cost of a property is based on its highest and best use. For example, if you have a tract of land in the midst of oil country, away from urban areas, you should assume a value based on using the property to generate oil income rather than building a rental property on the site. The cost approach is also affected by zoning laws that might impact the possible uses of the property.
The cost approach is used by lenders for new construction to release funds with the completion of each phase. Its main advantage is that it provides a current value based on unique conditions. However, this approach doesn’t account for the income the property will produce or the price of comparable properties.
In the income approach, value is linked to rental income via the property’s cap rate. The equation for the property value is:
Current Value = Net Operating Income / Cap Rate
The cap rate is extrapolated from market sales of comparable properties in the same neighborhood. The cap rate can be adjusted to account for unique features of the property, such as high-quality tenants or a less attractive façade. The final cap rate should be within half a percentage point of the local average for comparable properties.
To take an example, rental property with an annual NOI of $700,000 and a cap rate of 8% would be worth $8.75 million ($700,000 / 8%).
The advantage of the income approach is that it accommodates recent sale activity of comparable properties and can be adjusted for unique factors. Its disadvantage is that it doesn’t account for vacancy and collection loss, which leads to an overstated NOI and value. It also doesn’t account for necessary extensive repairs that will cut into future NOI.
Sales Comparison Approach
The sales comparison approach to valuation, also called the market approach, relies on the prices realized from recently sold comparable local properties as well as the asking prices on currently listed properties. The sales comparison approach is often used to appraise residential properties, such as single-family homes and multiunit structures.
The approach is to classify the property’s characteristics, such as number of baths and bedrooms, lot size and square footage, and then find recent local sales or current listings of similar properties. Sales should be as recent as possible, especially when the real estate market is in a dynamic phase.
The advantage of this method is that it relies on recent, relevant data to provide a good estimate of value. The disadvantage is that many properties have one or more unique features that affect the relevancy of comparable properties. Another disadvantage is that comparable sales might be too old to be an accurate indicator of current value, and/or current listings do not correctly reflect current values. Finally, the sales comparison approach doesn’t account for vacancy and collection loss, or unusual costs for repairs and other expenses. A trained real estate professional should be able to accommodate the differences among comparables to accurately tweak the property’s value.
Gross Rent Multiplier Approach
The GRM approach is similar in concept to the income approach. It differs in that the cap rate used is based on gross rent rather than NOI. The GRM is a number greater than 1, whereas the income approach’s cap rate is a percentage less than 1. In addition, this approach relies on gross rents rather than NOI, which means it doesn’t account for expenses, repairs or vacancy and collection loss.
The value calculation for the GRM approach is:
Property Value = Annual Gross Rents x Gross Rent Multiplier
For this to produce an accurate value, you need to know the GRM of comparable properties. This kind of information is often available from local commercial real estate agents and appraisers. As an example, to value a property that has annual gross rents of $90,000 and a GRM of 8, the property value would be ($90,000 * 8), or $720,000.
The advantage of this approach is its simplicity, and it works well if an accurate estimate of GRM can be secured. The disadvantages include the absence of expenses and vacancy and collection loss, and any difficulties identifying comparable properties and their GRMs. Like all of these valuation methods, the GRM approach is most useful when combined with other methods.
Researchers have expressed interest in using the Capital Asset Pricing Model (CAPM) to value real estate. The CAPM method assigns a variable called “beta” that represents the relationship between risk-adjusted returns from a given asset and those of a market. For real estate, the return on an income-producing rental property can be used to estimate its value by choosing a beta that relates the property to, say, the return on publicly traded real estate investment trusts. The complexity of CAPM and the lack of precise betas means that this approach is of secondary importance pending further research.
A quick-and-dirty method used to value an apartment building is value per door. For example, a comparable building with 10 apartments priced at $2 million would have a value per door of $200,000. If you want to value a comparable property with 14 apartments, you might multiply 14 by $200,000, giving a value of $2.8 million. This only makes sense if the apartments are roughly equivalent. It doesn’t accommodate differences in apartment size and quality, vacancy and collection costs, or unusual maintenance/repair costs.