Three Methods of Valuing Commercial Real Estate

When investing in real estate, knowing the value of a property is critical in determining an appropriate price to pay for the property, as well as whether it is a good candidate for certain investment strategies such as a value-add strategy.

When it comes to commercial real estate, there are various methods that can be used to value the property.

Here are three common approaches to valuing commercial real estate.

1. Sales Comparison Approach

We’ll start with the Sales Comparison approach, because it is very similar to how single-family residential property is valued, and therefore what most real estate investors are already accustomed to knowing.

In determining the value of the property, this method simply uses sales and pricing data on similar, or “comparable”, properties that have recently sold in the surrounding market.

2. Cost Approach

The concept of the Cost approach, sometimes also referred to as the Replacement approach, is pretty straight forward and relatively easy to understand as well. It basically estimates the cost of rebuilding the property from the ground up with present day market conditions and prices.

More specifically, the Cost approach looks at the value of the land plus the depreciated value of improvements. It takes into account the cost of the land, materials, labor, and other items that would be required to completely rebuild the property, assuming that the price of the property would be the same as what it would cost to build it from scratch. The depreciation of materials is also considered in the equation.

3. Income Approach

The Income approach is the primary and most often used method in valuing apartment communities. As the name implies, this approach calculates the value based on the income generated by the asset.

A great benefit for multifamily real estate investors about the Income approach is that it looks at the apartment based on its current and potential performance as a business.

The formula for the Income approach is as follows:

Net Operating Income / Cap Rate = Value

Net Operating Income (NOI) is the net income generated by the apartment building after expenses, but before paying debt. As such, in order to determine the NOI, one needs to know the gross income and all expenses.

Cap rate, short for capitalization rate, is the rate of return on the property as an investment, based on the income and specific to the market and class type (e.g., Class A, B, C) of the property. This is a market cap rate. The best way to determine what cap rate to use when valuing properties in a given market is to talk to brokers or lenders who operate in that market about the current cap rates for the various classes of property.

As an example of the Income approach, say we’re looking at an apartment building that has an NOI of $273,000 and a cap rate of 5.5. The value would be as follows:

$273,000 / .055 = $4,963,636

An important aspect of the formula to understand is that NOI has a direct relationship with the value, while cap rates have an inverse relationship with that value. In other words, as NOI increases, the value of the property will also increase. However, as the cap rate increases, the value of the property will decrease.

To demonstrate this relationship, let’s assume in our example above that the NOI increased to $310,000, while the cap rate remained at 5.5. In this case, the valuation would also increase as follows:

$310,000 / .055 = $5,636,363

However, if the NOI in our original example remained flat while the cap rate increased, then our valuation would go down as follows.

$273,000 / 7.0 = $3,900,000

For these reasons, experienced multifamily investors focus heavily on selecting markets and submarkets with competitive cap rates, and evaluating actual income and expense numbers during the due diligence phase.

Carefully studying and knowing our markets and submarkets is how we know we’re getting a good cap rate. Then, our focus becomes increasing the value of the asset by increasing its NOI.

Conclusion

There are various methods to determine the value of commercial real estate, including the Sales Comparison, Cost, and Income approach, with the Income approach being the most common. Real estate investors should understand these valuation methods in order to avoid overpaying for properties and ending up in poor performing investments.