I am often asked how much a commercial real estate property is worth from clients interested in buying commercial property. My answer is it depends on your investment objectives, property type, and local market conditions.
There are 3 basic approaches to estimating the market value of a commercial property: sales comparison, cost approach, and income approach. Each of these commercial real estate valuation methods has numerous variations so it’s important to apply the right approach based on the property type and market characteristics.
Sales Comparison Approach to Market Value
The sales comparison approach relates the value of a property to similar properties that are currently listed for sale or that have been sold historically. Realistically no two properties are identical so adjustments need to be made for the differences in the age, size, location, condition, building/land ratio, zoning, tax policies, date of sale, and other characteristics and conditions that would influence a property’s market valuation.
Adjusting the comparables for each variance will allow you to select the values, giving greater weight to the comparables more similar to the subject property. The more similar, the more reliable they are considered. At the end of the day the sales comparison approach is the price a purchaser is willing to pay and the seller is willing to sell for in an open competitive market.
The sales comparison approach works best when there are plenty of recent sales of comparable properties. The more properties that have recently sold makes it easier to find and select the most comparable.
Income Approach to Market Value
The income approach is is applied on income producing properties and is based on the premise that a relationship exists between the income a property produces (future benefits) and its value. The net operating income that an investor can predict will be generated for the length of ownership would be considered the future benefits. Two methods used to determine value based on income are the direct capitalization method and the discounted cash flow model.
Direct Capitalization Method
This method converts a one year stabilized net operating income (NOI) into a market value for the property. The formula is V = I/R. For example if you know the NOI is $50,000 and the asking sales price or sold price is $500,000 then you know the Cap rate is 10%. Then you compare the cap rates of all the comparable properties.
Discounted Cash Flow Model
This is a variation of the Cash Flow Model and used when uneven cash flows are anticipated. This model determines property value by discounting each years NOI and final sales proceeds to a present value (PV)
The most likely to purchase income producing properties are investors which is why the income approach is the best choice to value non owner occupied properties.
Cost Approach to Market Value
The cost approach considers the current cost of rebuilding a property minus accrued depreciation (physical deterioration, functional obsolescence, and external obsolescence). This approach is based on the premise that a property’s value is influenced by the cost to produce a comparable property. The logic is that a rational and informed buyer would pay no more for an existing property than the cost to build a substitute property with the same utility.
The cost approach is used most often when sales comparison data is lacking, the property has not been built yet, or the it’s a special use property with few or no comparable sales.