Commercial properties are evaluated differently from homes. Therefore, if you are thinking of investing in commercial real estate, it's essential to understand how to use the three main approaches to establishing the value of a commercial real estate assets. Let's talk about them in this blog.
To use this approach in commercial real estate evaluation, you need to take the capitalization rate (cap rate) and divide it by the income the property generates. There are five steps to doing this:
Do note that even if a prospective commercial real estate asset seems like a great deal in terms of the cap rate, it's still important to see how it fares against other valuation methods, including the following:
The sales comparison approach is often described as a backbone of comparative market analysis in the world of real estate.
Also called the Market Approach, this method of estimating the value of a commercial property is particularly useful for multifamily buildings and other large-scale apartment rentals.
To use it, look at the sale prices of like-properties sold recently in the same area. These properties are called 'comps' or comparable.
Make sure that they are within a short distance of the commercial property you want to evaluate and that they share similar characteristics that you can use as points of comparison.
The approach involves looking at demographics, infrastructures, leasing trends, and other factors that can profoundly impact the value of the property. It's also important to look at physical features, including the size, the age of the structure, its condition, and other essential elements.
As you can see, there's a long list of characteristics that investors and appraisers look at when evaluating the value of a commercial property. Let's talk about some of the most common ones used in this approach:
It's important to understand that the sales comparison approach is not an exact science.
Outside factors, including the job market, the overall state of the commercial property market, and the status of the economy, can all impact how much commercial property is sold for and how long it takes to sell.
While the sales comparison approach can be helpful, it is by no means an official appraisal. You will need to request a formal review from an unbiased and independent professional appraiser for the most accurate results.
This method of evaluating a commercial property is handy for buyers who may be hesitant about buying a building that they think might cost less if they built it from scratch. It is also often used in evaluating new constructions.
In this approach, the commercial property's value is equal to the sum of (1) the value of the land on which it sits and (2) the costs of construction minus depreciation.
This approach allows buyers to see if they are spending less by buying a commercial property that has already been built instead of constructing it from scratch. It is commonly applied to commercial real estate assets that are tricky to sell because they have particular uses, such as hospitals, schools, gov't buildings, churches, and libraries.
In addition, these assets generate little to no income, so the sales comparison and the income approach cannot be used on them.
Commercial construction loan lenders often require the cost approach because any income value or market value is contingent on project standards plus completion.
Construction projects are usually reappraised at different stages of the building process before funds are released for the next completion stage. Insurance appraisals also typically use the cost approach in underwriting policies.
Interestingly, many experts say that a cost approach appraisal can reveal whether or not it is the right time to buy a specific property. If the resulting evaluation comes in below market, the market may be overrated.
And conversely, appraisals above-market pricing may indicate a buying opportunity. This does not apply when the commercial property is either over-improved or under-improved for its location.
In this case, there's a need to accurately estimate the value of improvements in order to precisely determine the value of the property—and this is not possible using just this approach.
