One of the most critical factors in determining whether to include a commercial property in your investment portfolio is the value of the said property. As an investor, success in the commercial real estate space is almost impossible without the ability to properly value properties. So, how do you value commercial property?
How Do You Value Commercial Property?
You can determine the value of a commercial property primarily by using its capitalization rate. Generally speaking, the capitalization rate helps you determine the expected rate of return of the commercial property. However, factors like below-market rents, debts, and financing are not considered.
As a result, experienced commercial investors combine several other valuation methods to assess commercial properties. These other valuation methods include the sales comparison approach, the cost approach, the value per door approach, and the discounted cash flow approach, among others.
Primary Valuation Methods for Commercial Real Estate
While several valuation methods can be used in determining the value of properties, some of these methods have been continually favored by investors and appraisers.
Each of these valuation methods is more suitable for certain types of commercial properties than others. Investors and appraisers mix and match these valuation methods to achieve a more holistic idea of the property’s value. Here is a rundown of the primary valuation methods for commercial real estate:
Capitalization Rate Approach
The capitalization rate approach is one of the most popular ways to value properties. This method, also known as the income capitalization approach, takes into account the amount of income that the property generates for the owner. In other words, this approach determines the value of a commercial building based on the income it generates.
The capitalization rate, or cap rate, is the cash on cash returns expected by the investor, assuming they bought the property in all cash. To get the cap rate, you divide the net operating income of the property by its sale price.
Sales Comparison Approach
The Sales Comparison Approach is one of the simplest valuation methods used by investors in determining the commercial value of a property. This valuation method considers comparable commercial properties that have recently been sold or listed in the same area. The equivalent properties often have to be similar in size and use.
Using the values of the comparable properties as a range, the specific value of your commercial building is then adjusted based on significant differences. These include the following:
- Age of the property
- Physical condition
- Land-to-building ratio
- Price per square foot
- Income and tenant profiles
The cost approach or the replacement cost approach is slightly more complicated than the previous valuation methods. This method considers the cost it would take to replace a building from scratch, including the cost of the land. When assessing the property, the value is adjusted for factors like:
- Physical condition.
The rationale behind this method is to determine whether it costs less to build a new building or purchase an existing one and make renovations. It helps investors to determine the maximum they can spend on a commercial property. If it costs the same thing or more to build a similar property close by, the valued property may not be worth buying.
Value Per Door Approach
The value per door (VPD) approach is a valuation method that considers the number of doors in multi-unit commercial real estate like apartments and condos. To value a commercial building using this method, you divide the property’s price by the number of doors or apartment units available.
Keep in mind that you only get an average value per apartment as the available units are often different from one another, particularly in terms of size and layout. This is a factor that you have to take cognizant note of.
Discounted Cash Flow Approach
The discounted cash flow approach is widely accepted because it is the only valuation method that factors in a property’s future performance and the time value of money. This method determines the present value of a commercial building by analyzing the future cash flow of the property using a discount rate.
In valuing a property, Investors often have to consider factors like quality of management, long-term risks, and market trends. If the result obtained from the discounted cash flow analysis is higher than the current price of the property, then it is worth purchasing.
Commercial properties require a lot of careful analysis, knowledge, and expertise whether you are buying, selling, looking to revalue for taxes, or even refinance. If you are looking to invest in the Cincinnati MSA, having the expertise in valuing commercial properties, like Si Vales Valeo Real Estate, can be very instrumental. They are experts in market research and CRE analysis, due diligence, negotiations, and transaction management.
Do You Need to Value Commercial Properties?
Yes, you need to value commercial properties, especially before you buy them. Buying a commercial real estate property is a big deal, one that needs you to be armed with all the information you can get to make a sound decision. You also need to value your commercial property when they are sold, developed, leased, insured, mortgaged, or taxed.
Which Valuation Method Is Right?
There is no correct valuation method for commercial properties. Each of the methods has its merits and demerits and suitable applications. It is best to combine at least two or more of them.
Picking the suitable valuation method is very important and is dependent on each scenario, considering the type of property and its use. Accurate valuations help you make the most informed decisions. It is best not to limit yourself to just one of these valuation methods. You should consider taking an average of at least two methods or more.